The central bank as the middleman of the money markets
Deputy Governor of Eesti Pank
Are you interested in what goes on in money markets? How about when it directly affects the health of the economy and job-creation? The question has come up once again of whether euro area commercial banks have enough spare liquidity to give out loans to companies and thereby support the economy. Central banks have an important part to play in building confidence here.
In simplified terms, the people who trade money in money markets have either too little or too much money. The systems works for both sides because the one is not seeing its money lying idle, while the other receives the money it needs for its business. It is standard practice for commercial banks to borrow money from the market on a daily basis but if a day came when they were unable to do so because a lack of trust was dominating the money market, then they would have to limit lending. This would cause a chain reaction of difficulties in corporate financing and job losses, creating a series of economic challenges.
In the second half of 2011, tension in the money markets rose rapidly. In response, the Eurosystem of euro area central banks ran two operations in December 2011 and February 2012 that allowed euro area commercial banks to take out unlimited three-year loans against securities, called Very Long Term Refinancing Operations or VLTROs. Altogether commercial banks borrowed 1 trillion euros.
Was this an extraordinary move by the euro area central banks? Before the crisis central banks mostly offered loans with one-week maturity and the maximum offered was three months. During the crisis central banks extended the maturities of loans up to a year in order to give commercial banks more confidence in lending. In the VLTROs, loans were issued for three years, which is an unprecedented duration. Before the crisis some 450 billion euros of loans had been issued to the commercial banks by the central banks, but during the crisis this figure went up to 700 billion euros. The VLTROs took the loans issued to commercial banks up to 1.2 trillion euros. Therefore it was indeed an extraordinary step in both loan maturity and magnitude that was taken to restore confidence in the money markets.
The first VLTRO saw 523 banks take part and the second had 800, which can largely be divided into two groups. One group consisted of banks with a genuine need for money as they were not able to raise the usual amount of financing from the money market and so took the liquidity support provided by the VLTROs. The other group were strong banks, who participated in the VLTRO largely for precautionary reasons in order to build up liquidity just in case. The banks that borrowed in the VLTROs were allowed to start repaying their loans early after only one year.
During the last year and a half the general situation in the financial markets has improved significantly. The confidence of market participants has improved following the recapitalisation of banks, the plan to create a European banking union and the Outright Monetary Transactions or OMT programme created by euro area central banks. The OMT set clear and specific rules letting central banks offer support to markets for sovereign bonds. As the situation has improved it is not surprising that banks have quite enthusiastically taken the chance to repay VLTRO loans before their due date. Of the trillion euros borrowed, banks have repaid almost a third, meaning the total of loans issued by euro area central banks has dropped to around 800 billion euros.
Long-term loans from euro area central banks to commercial banks proved successful primarily because they were a simple and transparent measure that alleviated the crisis of trust in the interbank money market. Without this, commercial banks might have restricted lending, and that in turn would have worsened the economic difficulties of the euro area. If financial markets should suffer again setbacks and trust between banks should fall in consequence, then euro area central banks stand ready to intervene again. Whether they do this through very long-term loans or some other tool will depend on the situation and what is needed, but it is vital that banks can play their role as business financers in order to support the recovery of the economy.