Eurozone Watch

Today, for the second day in a row, the ECB acted as a fire bregade for financial markets. After running a special tender on Thursday and pumping an extra €95 bn of over-night money into the market, it today again provided banks with €61 bn of extra liquidity. [Just to put those figures into perspective: Total euro base money adds up to about €800 bn, of which a little above €400 bn is borrowed by commercial banks from the central bank. The ECB on Thursday thus temporarily added more than 10 percent to the monetary base and almost 25 percent to the borrowed base.]

While it is still not clear how the global liquidity crisis and the fallout of the US subprime mortgage market will play out, one thing stands out: The ECB has acted extremely swiftly, extremely calmly and in exactly the right way - a rare occurence among Eurozone governance institutions.

When money markets opened on Thursday morning with the news of BNP Parisbas having to close three funds hit by the subprime crisis, banks became increasingly reluctant to lend money in the money market to other banks. Media reports quote anonymous traders having been ordered by their superiors not to lend because of doubts whether one would be able to get liquidity should need be. Obviously, the latest news had created a confidence crisis among banks. As subprime losses seem to pop up in unexpected places (who would have thought that a medium sized German SME bank, the IKB, might suddenly run potential losses of several billion euro due to a crisis in the US subprime mortgage market?), banks decided that it would be safest not to lend to anyone. Interest rates in the money market climbed up above 4.6 percent before the ECB stepped in with its special tender and provided unlimited liquidity to all banks which had collateral to borrow against and pushed the interest rate down to 4 percent.

From central banking theory we know that this was exactly what a central bank is supposed to do. In order to preserve the stability of the banking sector, it needs to keep the markets liquid as illiquidity of banks can quickly turn to insolvency if assets cannot be sold quickly. There is no inflationary risk related to this move as the liquidity is only provided temporarily and there is no moral hazard problem as those who have lend rectlessly are not bailed out. With this action, the ECB has proved sceptics wrong who had suspected that the ECB might not act as a lender-of-last-resort because of its unique supra-national structure in which financial supervision is done at the national level and not even necessarily at the central banks which are linked to Frankfurt. Moreover, the ECB has shown that it can be able to act boldly without the lead from the Federal Reserve. In fact, the crisis management of the past days were the first occurence in which the ECB has dealt with a looming crisis on its own.

But there is more to this move. By moving boldly, the ECB has helped to overcome another flaw of EMU: The fragmentation of financial oversight. Part of the confidence crisis in the money market might have to do with the segmentation of supervision in Europe. While there is a EU wide regulation of financial markets, supervision remains a national responsibility. Moreover, countries differ not only in the way they supervise, but even in the basic institutional structure of supervision. In some countries (Spain, Italy, Ireland) the central bank oversees commercial banks. In other countries (i.e. Austria), a government department is responsible for this task. Germany and France have responsibilities shared by the central bank and a special banking supervisor. Securities markets and Insurance again might be supervised by a different institution.

The result of this fragmented structure is that one bank cannot necessarily be sure that supervisors in another EMU country actually have a close look on the subprime risks hidden someplace in the counterpart’s balance sheet. It might thus not be a coincidence that European banks have thus become more reluctant to lend money to other banks in the money markets than their US counterparts even though so far more bank failures have occured in the US. Maybe the confidence crisis was at the bottom a crisis of confidence in EMU financial supervision.

Once the dust settles, there might be renewed calls about a centralisation of financial sector supervision in Europe. So far, EMU might have prevented a banking crisis thanks to the farsighted central bankers in Frankfurt. Two cheers for the ECB!