Wednesday, August 15, 2007

The ECB as a lender of last resort 

On the Real Time Economics blog early this morning, Robert Eisenbeis, outgoing director of reserach at the Atlanta Federal Reserve, wonders what the European Central Bank is doing with the liquidity crisis from last week, now apparently well in hand.
That the ECB flooded the market with liquidity is both interesting, and understandable, given that the ECB doesn�t have Lender of Last Resort (LLR) powers. What should have happened (and this is still a missing piece of information) under the current arrangements within the European system of central banks is that BNP, or any other bank experiencing a liquidity problem, should have had access to its respective central bank�s Lombard facility. (My link -- kb) But the ECB stepped in ahead of the national central banks. The ECB does have the authority to provide liquidity, but doesn�t have systemic risk responsibility, except for payments system stability. The event points out how important it is for the ECB to have its LLR powers clearly defined, and there is a need to ensure coordination across the two functions.
The ECB has always been a little secretive about its role as a LLR. Patricia Pollard quotes ECB board member Tommaso Padoa-Schioppa, "To the extent that there would be an overall
liquidity effect that is relevant for monetary policy or a financial stability implication for the euro area, the Eurosystem itself would be actively involved." Former ECB head Wim Duisenberg says in the same article, "The Governing Council has this issue well under control but will never make anything public in this regard."

Also, the ECB sets a marginal lending facility rate that is, like the discount rate here in the States, set at a penalty of 100 basis points over refinancing rate (equivalent to our Fed funds rate.) Those funds are available through the national central banks. This is where Eisenbeis would have had BNP and IKB Deutsche Industriebank go to get credit.

The big issue I see here is that the national banks cannot provide discount loans to financial institutions holding paper that is non-marketable, because it would not be able to assess the value of the collateral. Particularly for DI, a commercial paper crunch means you don't have collateral. They would have needed to pledge other assets. True, you do not want to bail out banks and funds that have made bad loans, but if the European markets faced a substantial liquidity crunch, it's hard to fault them.