European Monetary Policy Instruments – “Everything that your own bank does.”

Future ECB Headquarters in Frankfurt am Main

“Achieving a single monetary policy entails defining the instruments and procedures to be used by the Eurosystem in order to implement such a policy in a uniform manner throughout the Member States whose currency is the euro.”

This the introduction of 123 pages of guidelines that the European Central Bank (ECB) has written to inform people about its monetary policy instruments. A fantastic teaser that encourages to keep on reading, I think!

I will try another one: On three pages, I will try to explain, as simply as possible, how the ECB puts its monetary policy in practice.

The ECB does everything that your own bank does: It buys and sells securities in financial markets, it lends money to banks, and it accepts deposits. There are two major differences: First, the ECB doesn't do this primarily for profit, but to “keep price stability and support economic policies in the EU”. Second, it can, in addition to the above services, impose minimum reserve requirements on banks. This is a little bit like private banking: You will not be accepted as client if you have only a few 1,000 € to invest.

The ECB uses its own terms to describe monetary policy instruments:

• Buying and selling securities in financial markets become open market operations.
• Deposits and lending become standing facilities for banks.
• The minimum amount that you have to put on the table to become a private bank's client is called minimum reserve requirements.

Two bodies are in charge of monetary policy in the Eurozone – the European Central Bank (ECB) and national central Banks (NCB) in each member state.

Open market operations

To understand open market operations, it is best to ask yourself two questions:

• What does the ECB intend to achieve?
• How can the ECB achieve its goals?

What does the ECB intend to achieve?

First, the ECB may want to provide liquidity to the economy, either in a regular and standardized way or on an ad hoc basis.

Regular open market operations can take the form of main refinancing operations or longer-term refinancing operations. Main refinancing operations are made through weekly tenders and mature weekly. Longer-term refinancing operations are reverse transactions with monthly frequency and a three months maturity. NCBs execute both main- and longer-term refinancing operations.

In the ad hoc scenario, we talk about fine tuning operations. With such transactions, the ECB manages the liquidity situation in the market and steers interest rates.

Second, the ECB might want to adjust the structural position of the Eurosystem vis-à-vis the financial sector. We talk about structural operations here.

How can the ECB achieve its goals?

They dispose of five major instruments:

• Reverse transactions designate repurchase agreements and collateralized loans. The ECB does reverse transactions for all of the above goals.
• Outright transactions designate purchases or sales of eligible assets in financial markets. They are used for structural operations, without standardized frequency, and on a bilateral basis. An outright purchase provides liquidity, whereas an outright sale absorbs liquidity.
• For structural operations, the ECB can also issue debt certificates with a maturity of less than 12 months. The certificates are freely transferable and carry interest by issuing them at a discount and paying back only the nominal upon maturity.
• The ECB uses foreign exchange swaps for fine-tuning operations. These swaps involve only widely traded currencies and are done in accordance with standard market practice. They can provide or absorb liquidity, incur any frequency or maturity, and are executed trough tenders or bilateral procedures.
• Finally, the ECB can collect fixed-term deposits. It uses this instrument for fine-tuning operations and to absorb liquidity in the market. Deposits are made for a fixed term and at fixed interest rates. The ECB provides no collateral.

Standing facilities for banks

Let's ask ourselves the same questions again:

What does the ECB intend to achieve?

With standing facilities, the ECB can

• provide and absorb overnight liquidity,
• put monetary policy into practice, and
• bound overnight market interest rates.

How can the ECB achieve its goals?

The ECB can act through marginal lending facilities or deposit facilities.

Marginal lending facilities provide overnight liquidity to banks at predetermined interest rates. This is done upon delivery of adequate securities (collateral). In legal terms, the facilities can take the form of a repurchase agreement or a collateralized loan.

Deposit facilities allow banks to make overnight deposits with NCBs. The remuneration is the same for the entire Eurozone and fixed in advance. NCBs provide no collateral for deposits.

Current ECB Headquarters in Frankfurt am Main

Minimum reserve requirements for credit institutions

Minimum reserve requirements for banks contribute to the stabilization of money market interest rates. Interest on reserves with the ECB is the same as interest for main refinancing operations.

You might object that I sometimes oversimplify the complex ECB transactions. If you think so, I suggest you click on the link below and enjoy the European Central Bank's guideline.

Resource:

Guideline of the European Central Bank of 20 September 2011 on monetary policy instruments and procedures of the Eurosystem