The ECB as lender of first resort

The effective fulfillment of the lender-of-last-resort function of the central bank requires that during a liquidity crisis the central bank lend freely to an institution that is illiquid but not  insolvent (if assets can be held to maturity), against collateral that would be good during normal times but that may have become illiquid during disorderly market conditions, and at a penalty rate.  The requirement that lender-of-last-resort facilities are only offered on punitive terms is key to the minimisation of moral hazard and thus to discouraging future imprudent, reckless lending and borrowing.

The same principle of providing assistance to illiquid but solvent institutions only on punitive terms applies when market illiquidity rather than funding illiquidity is the problem facing the troubled private financial institution and the central bank intervenes as market maker of last resort.

Any illiquid assets the central bank accepts as collateral in repos, at the discount window or at any of the more recently created special liquidity facilities, such as the Term Securities Lending Facility and the Primary Dealer Credit Facility in the USA or the Special Liquidity Scheme in the UK, must be valued or priced in a way that ensures that the transaction does not involve a subsidy from the central bank to the borrowing institution.  The repo, collateralised loan or swap should earn the central bank an appropriate risk-adjusted rate of return.  The same would apply if the central bank purchased illiquid private securities outright from a financially challenged private financial institution.  There is nothing wrong in principle with the central bank taking credit risk onto its balance sheet, as long as it earns a rate of return that adequately compensates it for that risk.

There is a growing suspicion in the markets that the ECB is subsidizing some euro area banks that are eligible counterparties at its discount window (the Marginal lending facility) or in repos, by overvaluing or overpricing illiquid collateral offered to the Eurosystem by these euro area banks.

According to the ECB’s handbook, The implementation of monetary policy in the euro area, September 2006, when a market reference price is available for a security offered as collateral to the ECB or one of the National Central Banks of the euro area, that market price is used to value/price the security. “In the absence of a representative price for a particular asset on the business day preceding the valuation date, the last trading price is used. If the reference price obtained is older than five days, or has not moved for at least five days, the Eurosystem defines a theoretical price.” The valuation/price assigned to the collateral – either a market reference price or a theoretical price – is subject to a further liquidity haircut (or discount).  The key problem is that while the haircuts (as a percentage of the valuation) are known, because they are published by the ECB, the valuations are not.  This does not matter when there is a market reference price.  When there is no market reference price but instead a theoretical price is used, the absence of information on the actual valuation represents a serious deficiency in the Eurosystem’s accountability for the use of public resources .

The issue is of more than theoretical interest.  The past year (2007) saw the collapse of an out-of-control property price boom/bubble and a construction boom in Spain which at its peak accounted for about 18 percent of Spanish GDP. This year, Spanish commercial banks, heavily exposed to the Spanish construction and housing sector, are reported to have repoed at least  € 46 bn worth of their (often illiquid) assets in exchange for ECB liquidity. The Spanish construction sector is dead in the water and house prices in Spain are falling, exposing banks to the risk of negative equity for their mortgage holders.  As a result, some of the collateral offered by Spanish banks to the Eurosystem has been illiquid and has had t be valued at a theoretical price.  Some assets offered as collateral may have been non-marketable assets like mortgages.  According to the ECB’s handbook again, “Non-marketable assets are assigned a value corresponding either to the theoretical price or to the outstanding amount. If the national central bank opts for the valuation corresponding to the outstanding amount, the non-marketable assets may be subject to higher haircuts”.  For instance, non-marketable retail mortgage-backed debt instruments are subject to a valuation haircut of 20%.

The key problem is that, even if we know the haircuts, we cannot tell whether the ECB or the National Central Banks of the euro area are subsidising their counterparties when these offer illiquid or non-marketable collateral for which a theoretical price has to be established.  There are stories doing the rounds in the markets that suggest that the illiquid or non-marketable collateral offered by the Spanish banks has been priced not more than 5 percent below its notional or face value.  If true, this is likely to represent a wild overvaluation of the collateral offered by the Spanish banks, and an illegitimate subsidy of the Eurosystem to these Spanish banks.

I have made the point about the imporance of the availability in the public domain of both the Eurosystem’s methods for the pricing of illiquid collateral and the actual theoretical prices assigned to specific items of illiquid or non-marketable collateral on many occasions, both in public (e.g. on June 6, 2006 during a Q&A following a public lecture at the LSE by the President of the Bundesdbank, Axel Weber)  and  in private (recently at the Banque de France).  I always ask for the same two things.  First, the immediate publication of the the model or models used to compute theoretical prices for illiquid or non-marketable financial instruments.  Second, the publication (with an appropriate lag to respect commercial confidentiality) of the actual prices/valuations to each specific item of illiquid collateral offered to the Eurosystem. That information is still not in the public domain.

There is no justification for this.  Neither the citizens of the EU, nor the European Parliament’s Committee on Economic and Monetary Affairs (and in particular its Sub-Committee on Monetary Affairs (one of the bodies to which the ECB/Eurosystem is formally accountable) can hold the ECB to account if they cannot verify whether the Eurosystem’s repos earn a proper risk-adjusted rate of return.  The ECB and the National Central Banks of the euro area play with public money – tax payers’ money.  The European Parliament’s Committee on Economic and Monetary Affairs should request (polite for demand) this pricing information from the ECB. It’s time the ECB faced some substantive accountability for the first time in its existence.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website