Monetary policy operations

3.1.3 Monetary policy operations

In accordance with its monetary policy strategy, the ECB steers short-term money market rates by signalling its monetary policy stance and by managing the liquidity situation in the money market. As well as steering interest rates by managing liquidity, the ECB can also signal its monetary policy stance to the money market by changing the conditions under which the Eurosystem is willing to enter into transactions with the money market.

In the operations of the Eurosystem, the ECB also aims to ensure an orderly functioning of the money market and to help banks meet their liquidity needs in

a smooth and well-organised manner. This is achieved by providing regular refinancing to the banks and facilities that allow them to deal with end-of-day balances and to cushion transitory liquidity fluctuations.

Ta b l e 3 Eurosystem monetary policy operations

The operational framework of the Eurosystem is based on provisions laid down in the Statute of the ESCB. It has been designed in compliance with Article 105 of the EC Treaty, according to which the Eurosystem “[…] shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources […]” and in line with the following principles:

• operational efficiency, which enables monetary policy decisions to feed through as precisely and as quickly as possible to short-term money market rates;

• equal treatment of financial institutions, irrespective of their size and where they are located in the euro area;

• the decentralised execution of the Eurosystem’s monetary policy operations through the NCBs;

• simplicity, transparency, continuity, safety and cost efficiency. Simplicity and transparency ensure that the intentions behind monetary policy

operations are correctly understood. The principle of continuity aims at avoiding frequent major changes in instruments and procedures, so that central banks and their counterparties can draw on experience when participating in monetary policy operations. The principle of safety requires that the Eurosystem’s financial and operational risks be kept to a minimum. In particular, all lending to credit institutions must be collateralised as required by Article 18 of the Statute of the ESCB. Cost efficiency means keeping down the operational costs to both the Eurosystem and its counterparties.

Box 12 O p e n m a r ke t o p e r a t i o n s a n d s t a n d i n g f a c i l i t i e s

The Eurosystem’s open market operations can be divided into the following four categories according to their aim, regularity and the procedures followed:

- main refinancing operations; -

longer-term refinancing operations; -

fine-tuning operations; -

structural operations.

Main refinancing operations

The main refinancing operations are the most important open market operations and represent the key monetary policy instrument of the Eurosystem. They provide the bulk of liquidity to the banking system and play a pivotal role in steering interest rates, managing the liquidity situation in the market and signalling the stance of monetary policy.

Main refinancing operations are conducted on a weekly basis and have a maturity of one week 2 . They are executed through standard tenders, a type of tender conducted in accordance with a pre-announced schedule and executed within a period of 24 hours from the announcement of the tender to the communication of the results. All counterparties fulfilling general eligibility criteria may participate in these operations. In principle, all credit institutions located in the euro area are potentially eligible counterparties of the Eurosystem.

Longer-term refinancing operations

In addition to the weekly main refinancing operations, the Eurosystem also executes monthly longer-term refinancing operations with a three-month maturity.

2 In March 2004 the maturity was shortened from two weeks to one week.

Box 12 O p e n m a r ke t o p e r a t i o n s a n d s t a n d i n g f a c i l i t i e s ( c o n t ’d )

These operations are aimed at providing longer-term liquidity to the banking system. This prevents all the liquidity in the money market from having to be rolled over every week. Like the main refinancing operations, longer-term refinancing operations are conducted as standard tenders in a decentralised manner, and all counterparties fulfilling general eligibility criteria may participate.

Fine-tuning operations

The Eurosystem may also carry out open market operations on an ad hoc basis, i.e. fine- tuning operations. Fine-tuning operations can be liquidity-absorbing or liquidity- providing. They are aimed at managing the liquidity situation and steering interest rates in the money market, in particular to smooth the effects on interest rates of unexpected liquidity fluctuations in the money market.

In view of their purpose, fine-tuning operations are normally executed through “quick” tenders. These take one hour from their announcement to the communication of the allotment results. For operational reasons, only a limited number of selected counterparties may participate in fine-tuning operations. Fine-tuning operations can also

be executed through bilateral procedures, where the Eurosystem conducts a transaction with one or a few counterparties without a tender.

Fine-tuning operations are normally executed in a decentralised manner by the NCBs, but the Governing Council can decide, under exceptional circumstances, to have bilateral fine-tuning operations executed by the ECB.

Structural operations

The operational framework also provides the Eurosystem with the possibility of conducting structural operations. Such operations are designed to adjust the structural liquidity position of the Eurosystem vis-à-vis the banking system, i.e. the amount of liquidity in the market over the longer term. They could be conducted using reverse transactions, outright operations or the issuance of debt certificates. So far, the Eurosystem has had no need to conduct operations to adjust the structural liquidity position of the banking system.

Standing facilities

The marginal lending facility provides overnight loans from the central bank against collateral at a predetermined interest rate. The interest rate on these overnight loans is normally substantially higher than the corresponding market rate. As a result, credit institutions only use the marginal lending facility to obtain funds as a last resort. Since access to the marginal lending facility is only limited by the amount of collateral available, the interest rate on the facility normally provides a ceiling for the overnight rate in the money market.

The deposit facility, by contrast, allows banks to make overnight deposits with the central bank at a predetermined interest rate. The interest rate on these overnight deposits is normally substantially lower than the corresponding market rate. Therefore, counterparties only make overnight deposits with the Eurosystem if they cannot use their funds in any other way. Just

Box 12 O p e n m a r ke t o p e r a t i o n s a n d s t a n d i n g f a c i l i t i e s ( c o n t ’d )

as the interest rate on the marginal lending facility provides a ceiling, the interest rate on the deposit facility normally provides a floor for the overnight rate in the money market.

The incentive for banks to use the standing facilities is significantly reduced by the rates applied to them. Thus, the average daily use of the standing facilities is in general limited. It mostly remains below €1 billion, demonstrating that they serve only to provide and absorb liquidity in exceptional circumstances.

Open market operations (see Box 12) are the most important group of monetary policy operations. They are generally executed by the NCBs on the initiative of the ECB, usually in the money market, i.e. the market in which the maturity of transactions is generally less than one year. Open market operations play an important role in steering interest rates, signalling the stance of monetary policy and managing the liquidity situation in the money market.

The standing facilities (see Box 12) – the marginal lending facility and the deposit facility – are available to the Eurosystem’s counterparties on their own initiative. By setting the rates on the standing facilities, the ECB determines the corridor within which the overnight money market rate can fluctuate.

The operational framework is supplemented by the system of minimum reserves to be held by credit institutions with the NCBs (see Box 13). The key functions of the minimum reserve system are to help stabilise money market interest rates and to enlarge the structural liquidity shortage of the banking system, increasing the demand for central bank refinancing.

Box 13 M i n i m u m r e s e r ve r e q u i r e m e n t s

The ECB requires credit institutions to hold deposits on accounts with the NCBs: these are called “minimum” or “required” reserves. The amount of required reserves to be held by each institution is determined by its reserve base multiplied by a reserve ratio.

The reserve base of an institution is defined in relation to the short-term liabilities on its balance sheet. Liabilities vis-à-vis other credit institutions included in the list of institutions subject to the Eurosystem’s minimum reserve system and liabilities vis-à-vis the ECB and the NCBs are not included in the reserve base.

The first key function of the minimum reserve system is to stabilise money market interest rates. This function is performed by the averaging provision. This provision means that credit institutions’ compliance with reserve requirements is judged on the basis of the average of the daily balances on their reserve accounts over a reserve maintenance period of around one month. Credit institutions can thus smooth out daily liquidity fluctuations (e.g. those arising from fluctuations in the demand for banknotes), since transitory reserve imbalances can be offset by opposite reserve imbalances within the same maintenance period.

The averaging provision also implies that institutions can profit from lending in the market and run a reserve deficit whenever the shortest money market rates are above those expected to prevail for the remainder of the maintenance period. In the opposite scenario, they can borrow in the market and run a reserve surplus. This mechanism stabilises the overnight interest rate during the maintenance period and makes it unnecessary for the central bank to intervene frequently in the money market.

A second important function performed by the minimum reserve system is the enlargement of the structural liquidity shortage of the banking system. The need for credit institutions to hold reserves with the NCBs helps to increase the demand for central bank refinancing which, in turn, makes it easier for the ECB to steer money market rates via regular liquidity-providing operations.

The minimum reserve system was designed in such a way as to neither put a burden on the banking system in the euro area nor hinder the efficient allocation of resources. To achieve these objectives, credit institutions’ holdings of required reserves are remunerated at very close to short-term money market interest rates. The remuneration rate corresponds to the average, over the maintenance period, of the marginal rate (weighted according to the number of calendar days) in the main refinancing operations.

3 . 2 E X T E R N A L O P E R AT I O N S

As far as the external operations of the Eurosystem are concerned, Article 23 of the Statute of the ESCB entitles the ECB and the NCBs:

• to establish relations with central banks and financial institutions in other countries and, where appropriate, with international organisations;

• to acquire and sell spot and forward all types of foreign exchange assets and precious metals;

• to manage the foreign assets they hold; • to conduct all types of banking transactions in relations with third countries and

international organisations, including borrowing and lending operations.