Monetary policy in the euro area: lessons from the crisis and challenges ahead
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The document discusses lessons from the euro area crisis and ongoing challenges for monetary policy. It notes that while the ECB effectively dealt with liquidity issues, solvency problems involving banks and sovereigns were postponed. This led to a correlation between bank and sovereign risk that hindered the real economy. Current challenges include dealing with bank restructuring and maintaining accommodative financial conditions to support recovery, as interest rates remain too tight.
![Lessons from the crisis and challenges ahead
• The euro area has the tools to deal with a generalized liquidity crisis
• The role of the euro-system (ES) as intermediary of last resort in the inter-bank
market [provision of unlimited liquidity against good collateral ] was key after
Lehman for financial stability and the real economy (see quantitative work by
Giannone, Lenza, Pill and Reichlin EJ 2012)
• However, imperfect euro area architecture led to postponement of action to solve
underlying solvency issues involving banks and sovereign
• Persistence of solvency risks led to the balkanization of the financial market: the
inter-bank first, the sovereign later
• This led to a correlation of sovereign and bank risk, particularly detrimental for the
real economy since the euro area financial system is based on banks
• The second LTRO was not as successful as the first as a tool to sustain credit to the
real economy
• Challenges today are how to deal with bank capital (the asset quality review) in the
absence of a backstop
• But sustaining the incipient recovery also important (and related to the first
challenge) – financing conditions are to tight in the euro area and the ECB need to
get back in control of interest rates in the new global context](data:image/gif;base64,R0lGODlhAQABAIAAAAAAAP///yH5BAEAAAAALAAAAAABAAEAAAIBRAA7)
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Monetary policy in the euro area: lessons from the crisis and challenges ahead
- 1. Monetary policy in the euro area: lessons from the crisis and challenges ahead Lucrezia Reichlin London Business School September 2013
- 2. Lessons from the crisis and challenges ahead • The euro area has the tools to deal with a generalized liquidity crisis • The role of the euro-system (ES) as intermediary of last resort in the inter-bank market [provision of unlimited liquidity against good collateral ] was key after Lehman for financial stability and the real economy (see quantitative work by Giannone, Lenza, Pill and Reichlin EJ 2012) • However, imperfect euro area architecture led to postponement of action to solve underlying solvency issues involving banks and sovereign • Persistence of solvency risks led to the balkanization of the financial market: the inter-bank first, the sovereign later • This led to a correlation of sovereign and bank risk, particularly detrimental for the real economy since the euro area financial system is based on banks • The second LTRO was not as successful as the first as a tool to sustain credit to the real economy • Challenges today are how to deal with bank capital (the asset quality review) in the absence of a backstop • But sustaining the incipient recovery also important (and related to the first challenge) – financing conditions are to tight in the euro area and the ECB need to get back in control of interest rates in the new global context
- 3. The past five years have been tough for the EMU as a whole US and euro area recessions 2006-2012 -3.5 -3 -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 Q1-2006 Q2-2006 Q3-2006 Q4-2006 Q1-2007 Q2-2007 Q3-2007 Q4-2007 Q1-2008 Q2-2008 Q3-2008 Q4-2008 Q1-2009 Q2-2009 Q3-2009 Q4-2009 Q1-2010 Q2-2010 Q3-2010 Q4-2010 Q1-2011 Q2-2011 Q3-2011 Q4-2011 Q1-2012 Q2-2012 Q3-2012 Q4-2012 Q1-2013 Q2-2013 GDP growth, QoQ US recession EUR recession US gdp growth Euro Area gdp growth Source: OECD
- 4. Tensions in the money market money market rates and spreads 0.000 0.200 0.400 0.600 0.800 1.000 1.200 1.400 1.600 1.800 2.000 -1.000 0.000 1.000 2.000 3.000 4.000 5.000 6.000 1/2/2007 2/19/2007 4/10/2007 5/29/2007 7/16/2007 8/31/2007 10/18/2007 12/5/2007 1/25/2008 3/13/2008 5/5/2008 6/20/2008 8/7/2008 9/24/2008 11/11/2008 12/31/2008 2/18/2009 4/7/2009 5/28/2009 7/15/2009 9/1/2009 10/19/2009 12/4/2009 25/01/2010 12/03/2010 29/04/2010 16/06/2010 03/08/2010 20/09/2010 05/11/2010 23/12/2010 09/02/2011 29/03/2011 18/05/2011 05/07/2011 22/08/2011 07/10/2011 24/11/2011 12/01/2012 29/02/2012 19/04/2012 07/06/2012 25/07/2012 11/09/2012 29/10/2012 14/12/2012 05/02/2013 25/03/2013 Spread (right) EURIBOR 3m EUREPO 3-monthsSource: European Banking Federation “Greek crisis” contagionLehmanturmoil
- 5. ECB ACTION IN SECOND RECESSION NOT EFFECTIVE IN SUSTAINING LOANS - LIQUIDITY PROVISION AND LOANS TO CORPORATES: The second recession is different! 80 85 90 95 100 105 110 115 120 -25 -15 -5 5 15 25 35 45 55 2001Jan 2001Oct 2002Jul 2003Apr 2004Jan 2004Oct 2005Jul 2006Apr 2007Jan 2007Oct 2008Jul 2009Apr 2010Jan 2010Oct 2011Jul 2012Apr 2013Jan Eurobillions Loan flows (6m MA) and industrial production NFC Industrial production (right)Source: ECB 0 200 400 600 800 1000 1200 1400 1998W53 1999W29 2000W06 2000W35 2001W12 2001W41 2002W18 2002W47 2003W24 2004W01 2004W30 2005W06 2005W35 2006W12 2006W41 2007W18 2007W47 2008W24 2009W01 2009W30 2010W06 2010W35 2011W12 2011W41 2012W18 2012W47 Main refinancing operation
- 6. To understand current challenges need to look at what happened in the financial sector in the second recession
- 7. Leverage in the banking sector: not much has happened yet 0 2 4 6 8 10 12 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Bank capital to assets ratio (%) United Kingdom United States Euro area Source: World Bank
- 8. Bank, government and ESCB liabilities 0 1 2 3 4 5 6 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 2012Q1 2012Q3 2013Q1 EA liabilities (normalized by GDP) MFIs excluding ESCB Eurosystem General Government 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 2012Q1 2012Q3 2013Q1 EA liabilities MFIs excluding ESCB Eurosystem General Government
- 9. In both recessions banks increased their holding of government securities: MFI (excl. ESCB) holdings of government securities / total assets 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 3 3.5 4 4.5 5 5.5 6 6.5 2006Jan 2006Mar 2006May 2006Jul 2006Sep 2006Nov 2007Jan 2007Mar 2007May 2007Jul 2007Sep 2007Nov 2008Jan 2008Mar 2008May 2008Jul 2008Sep 2008Nov 2009Jan 2009Mar 2009May 2009Jul 2009Sep 2009Nov 2010Jan 2010Mar 2010May 2010Jul 2010Sep 2010Nov 2011Jan 2011Mar 2011May 2011Jul 2011Sep 2011Nov 2012Jan 2012Mar 2012May 2012Jul 2012Sep 2012Nov 2013Jan 2013Mar 2013May CEPR recessions Government securities of EA / total assets (%)Source: ECB
- 10. … but in the second is all domestic 0 200 400 600 800 1000 1200 1400 2006Q1 2006Q2 2006Q3 2006Q4 2007Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 BillionsofEuro MFI (excl. ESCB) assets: gov.securities, different counterparts CEPR recessions Extra Euro area Other Euro area DomesticSource: ECB
- 11. Questions • Does the banks’ accumulation of domestic sovereign debt eventually intensify the vicious spiral between banks and sovereigns and thereby prove counterproductive over the longer term? This issue goes beyond the crisis itself • Two scenarios can be envisaged: (a) provided that a combination of OMT and fiscal consolidation end up improving the public finances, you can look to a win-win if the banks’ capital rises on account of the capital gain on bond holdings; or (b) if fiscal situation worsens, the next iteration of the feedback is yet more magnified CHALLENGE AHEAD IS TO DEAL WITH SOLVENCY ISSUES! NEED AGENTS OTHER THAN THE CENTRAL BANK FOR THAT
- 12. Interest rates Difficult to control them through words only (ECB version of forward guidance) • Money market rates are determined by demand of liquidity by banks – banks are now giving back liquidity … • Long rates determined by global factors Once can argue that without further action on the policy rate the stance of monetary policy is excessively restrictive given the outlook
- 13. 0.18 0.185 0.19 0.195 0.2 0.205 0.21 0.215 0.22 0.225 0.23 1.20 1.40 1.60 1.80 2.00 2.20 2.40 2.60 02/05/2013 07/05/2013 10/05/2013 15/05/2013 20/05/2013 23/05/2013 28/05/2013 31/05/2013 05/06/2013 10/06/2013 13/06/2013 18/06/2013 21/06/2013 26/06/2013 01/07/2013 04/07/2013 09/07/2013 12/07/2013 17/07/2013 22/07/2013 25/07/2013 30/07/2013 02/08/2013 07/08/2013 12/08/2013 15/08/2013 20/08/2013 23/08/2013 28/08/2013 02/09/2013 05/09/2013 10/09/2013 Draghi's speech Zero-coupon 10Y Euribor 3M (right axes)Sources: European Banking Federation, Eurostat, ECB. Forward guidance?