Nikola Stakić* UDC 336.711(4-672EU) ; 338.23:336.

74
Original scientific paper

THE ROLE AND IMPORTANCE OF ECB’S

MONETARY POLICY IN THE GLOBAL
ECONOMIC CRISIS**

This paper presents the role and importance of the European Central Bank
(ECB) in the context of measures and effects that are being taken to repair the
consequences of the current economic crisis. The ECB, together with the Euro-
pean single currency, the euro, symbolizes long-lasting monetary integration of
the EU states. Such form of integration has created the possibility of a supra-
national action of ECB in the banking sector and financial markets in general.
Along with the other most important central banks in the world, the ECB applies
various unconventional instruments of monetary policy to stimulate economic
growth and development. In this context, the paper explains the nature and
mechanism of such measures in order to influence on the insufficient liquidity
in the financial markets.
Key words: ECB, monetary policy, non-standard measures, financial markets

1. Introduction

After the first indications of the global financial crisis in 2007 and its inten-
sification one year later (the bankruptcy of one of the largest investment banks
– Lehman Brothers), new circumstances were generated, which called for the
implementation of non-standard and unconventional measures of monetary
policy by the most significant central banks in the world. Addressing the issue
of insufficient international liquidity and boosting the weak aggregate demand
implied the establishment of new mechanisms that would be at the central
banks’ disposal within the scope of their instruments. After September 2008, in
the aftermath of the mentioned bankruptcy, the financial market, in particular
money markets have been hit by a considerable increase in insecurity and panic.
Interest rate spreads at the European, US an UK markets reached the unprece-
dented levels, whereas, on the other hand, the volume of transactions drastically
*
Nikola Stakić, MSc, Faculty of Business Studies, Megatrend University, Belgrade, e-mail:
[email protected]
**
Paper presented at the 10th N.E.W.S. Conference – Global University Network, held by
Megatrend University from 10th to 14th September 2013 in Belgrade.
Vol. 11, No 1, 2014: 41-52
42 Nikola Stakiæ
fell (especially when it comes to forward transactions). Effectiveness of transmi-
ssion mechanism of monetary policy was brought into question given that the
financial market players ended up in the position of a “liquidity trap”.
Such circumstances called for a swift and decisive reaction of monetary aut-
horities. In addition to carrying out expansionary monetary policy by means of
traditional instruments (including, for instance, reduction of reference interest
rates), the central banks presented a set of the so-called non-standard measures
in order to adequately adjust to the current developments. The mechanism and
forms of these measures somewhat differ among the central banks involved, but,
despite this, they all strive towards the same objectives – support to the financial
markets and prevention of the financial systems’ disruption, which would in the
mid term threaten the macroeconomic and price-related stability. The differen-
ces in the “design” of the central banks’ measures which are being topical from
the late 2008 depended on several factors: structure itself of the present standard
monetary policy measures, balance sheet size of the concerned central banks,
and structure of the financial systems of the region in which a certain country
was located.
The separateness of standard and non-standard measures of monetary
policy has been explicitly demonstrated through their effects on the financial
markets, especially if one follows in parallel the development before and during
the global financial and economic crisis. The mechanism of standard measures
of open market operations is rather familiar and many scientific reference books
analyze their impact on real economy and the price level. When it comes to non-
standard measures, however, the situation is somewhat different. By their nature,
they are located outside the regular scope of monetary actions and, as such,
impose the need for their further analyses and required scientific justifiability.
Many non-standard measures implemented from 2007 represent a modifica-
tion of the existing instruments and procedures used in monetary policy. These
modifications implied the changes in the role of the central banks themselves:
ranging from mediators at the interbank money market through holders and
portfolio managers to lenders of the last resort.
The existence of a single currency in a multi-country area can be seen to
create disincentives for individual governments to properly tackle fiscal and
structural policies as well as to safeguard financial stability. The crisis has shown
that the original institutional set-up of EMU only partially corrected for such
disincentives. Excessive debt and leverage had built up prior to the crisis, in pri-
vate and public, financial and non-financial sectors, with imbalances emerging
across the euro zone and elsewhere. The paper reviews the ECB’s specific non-
standard monetary policy responses in the three main phases of the crisis, which
mutated from a global financial crisis to a sovereign debt crisis in the euro zone
and was later intertwined with renewed strain in the banking system in parts of
the euro zone, with significant fragmentation across countries.

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 The role and importance of ECB's monetary policy in the global economic crisis 43
2. Quantitative easing

The most widespread and most frequently used non-standard measure of

monetary policy is so-called quantitative easing. In situations when traditional
instruments no longer have impact on macroeconomic aggregates because the
reference interest rate reached its lowest possible level, and at the same time there
is no other economic stimulus, central banks undertake a different set of mea-
sures. Namely, they purchase various forms of financial assets from commercial
banks and other (non)financial institutions, thus generating additional money
supply in order to inject “fresh” capital into the financial flows. This measure
differs from the typical buying or selling of government securities with a view to
impacting the reference interest rate. Quantitative easing increases the surplus
of banks’ reserves and causes an increase in financial assets prices, at the time
reducing their returns.
As opposed to open market operations where the focus is on short-term
government securities, when implementing quantitative easing central bank pur-
chase long-term government bonds in order to impact additional reduction of
long-term interest rates on the revenue curve (in the mentioned situations when
short-term interest rates are close to zero or zero, the classic monetary policy can
no longer reduce them in the long run). How does the process of quantitative
easing implementation actually work?
Direct injection of capital into the financial system by the central bank,
through purchasing mostly government securities, may have various effects
(Diagram 1). The sellers of financial assets acquire a surplus of cash which,
they may spend, thus triggering further economic activity. Alternatively, they
may purchase other financial assets, such as shares or corporate securities. This
results in a growth of prices of financial instruments, increasing the wealth of
their owners. Ownership may be direct or indirect, through a share in certain
intermediary financial institutions, such as, for instance, private pension and
investment funds. Growth of financial instruments’ prices also implies lower
revenues, which in turn leads to the lower borrowing costs for the corporate and
retail sectors. This additionally boosts the consumptions. On the other hand, the
banks are in the position to hold a surplus of reverses, which to a large extent
they can extend to their clients, thus enhancing their lending activity. However,
the question is whether commercial banks would react adequately or whether
they would be unwilling to extend loans, thus keeping the surplus of money as
part of their reserves. This is exactly why central banks may conduct the process
of quantitative easing with other financial institutions as well, which would then
involve the purchase of various corporate securities.

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44 Nikola Stakiæ
Figure 1: Quantitative easing implementation process

Source: Author

3. Financial structure of the euro zone

The euro zone’s financial structure differs from that of other large econo-
mies. Financial intermediaries – in particular banks – are the main agents for
channeling funds from savers to borrowers (ECB, 2007). Banks are the primary
source of financing for the economy, most obviously in the case of households.
As for firms, more than 70% of the external financing of the non-financial cor-
porate sector – that is, the financing other than by retained earnings – is pro-
vided by banks, and less than 30% by financial markets (and other funding).
In the United States it is the other way around (Figure 1). After the collapse of
Lehman Brothers, bank funding started contracting (i.e. a net redemption) at a
rate of €100 billion a year, in sharp contrast to its prior net expansion at a rate
which could go up to €600 billion in 2007. Part of the decline in bank funding
was offset by a rise in market funding: debt securities issued by corporations
(but also quoted shares issued) increased by more than €100 billion a year in
net terms1.

1
Cour-Thimann, P; Winkler, B; The ECB’s non-standard monetary policy measures, ECB
Working Paper No. 1528, April 2013, 7.
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 The role and importance of ECB's monetary policy in the global economic crisis 45
Figure 2: Funding of the non-financial corporations in the Euro zone and USA

Source: Eurostat, ECB and FED

Banks still play a crucial role in the transmission of policy interest rate decisi-
ons to the euro zone economy. In this respect, the ECB’s non-standard response to
the crisis has accordingly been primarily focused on banks. The operations mainly
consist of refinancing operations, to which a large number of counterparties are
granted access so as to ensure that the single monetary policy reaches the ban-
king system in all the euro zone countries. This is again different from the US set-
up, where the Federal Reserve Bank of New York implements monetary policy on
behalf of the entire Federal Reserve System and the operations consist mainly of
outright purchases and sales of assets in the open market, in line with the essenti-
ally market-based structure of the economy. The number of counterparties invol-
ved is relatively small, even after having risen during the financial crisis.
In Eurosystem refinancing operations, the individual national central banks
grant loans at normally uniform conditions across the euro zone to their coun-
terparties against assets pledged as collateral for a limited, pre-specified period.
The list of eligible collateral – about 40,000 assets with a combined value of aro-
und €14 trillion or around 150% of GDP in 2012 – contains a very wide range

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46 Nikola Stakiæ
of public and private sector marketable debt securities and also includes some
non-marketable assets2.
Since they steer the marginal cost of the refinancing of banks, the mone-
tary policy operations are at the beginning of the transmission chain of the
policy signal. The monetary policy stance is signaled by three key ECB interest
rates: the rates on the main refinancing operations, the marginal lending facility
and the deposit facility. Prior to the financial crisis, decisions and expectations
regarding the main refinancing rate were smoothly reflected in the money mar-
ket yield curve, which was the same throughout the euro zone. The interbank
market seemed fully integrated. The creation of EMU had thus been an engine
of financial integration: the distinction between a domestic transaction and a
cross-border transaction within the euro zone had disappeared. This also meant
that if bank transactions during the day led to a net payment outflow, the bank
would find the offsetting funding in the interbank market at uniform conditions
across the euro zone.

4. The ECB’s monetary policy response to the crisis

This section reviews how the ECB and the Eurosystem responded to the
financial crisis. For simplicity, the measures decided by the ECB’s Governing
Council are described in this paper as ‘ECB’ measures; they are actually imple-
mented by the Eurosystem as a whole. Beyond the period of financial turmoil
that preceded the financial crisis, it is useful for the purpose of the review to
distinguish between two phases, marked by the following:

1) The start of the global financial crisis in September 2008 (Lehman

collapse);
2) The start of the euro zone sovereign debt crisis in May 2010 (Greek crisis).

4.1. The global financial crisis and the ECB’s response

The ECB had already been actively amending its monetary policy imple-
mentation in the 13 months of financial turmoil preceding the eruption of the
global financial crisis in September 2008. Banks had started to have doubts
about the financial health of their counterparties in the interbank market. This
drove money market rates up and threatened the appropriate transmission of the
ECB’s interest rate decisions. From the first day of tensions in interbank mar-
kets on 9 August 2007, the ECB acted by accommodating the funding needs of
banks, which were seeking to build up daily liquidity buffers so as to reduce
2
Cour-Thimann, P; Winkler, B; The ECB’s non-standard monetary policy measures, ECB
Working Paper No. 1528, April 2013, 9.
Megatrend revija ~ Megatrend Review
 The role and importance of ECB's monetary policy in the global economic crisis 47
uncertainty about their liquidity positions. In particular, the ECB de facto pro-
vided unlimited overnight liquidity to banks, allocating €95 billion on the first
day. Later on, the ECB conducted supplementary refinancing operations with
maturities of up to 6 months, compared with a maximum of 3 months in normal
times3. To reduce bank liquidity uncertainty over the turn of the year, all bids
above the previous operation’s marginal rate were allotted in full in the last main
refinancing operation of the year. Temporary swap lines were established with
other central banks, primarily to address the mounting pressure in short-term
US dollar funding markets. As a result, the tensions in the short-term segment of
the euro zone money market abated considerably.
Following the bankruptcy of Lehman Brothers on 15 September 2008, the
uncertainty about the financial health of major banks worldwide led to a virtual
collapse in activity in many financial market segments. Banks built up large liqu-
idity buffers, while shedding risks from their balance sheets and tightening loan
conditions. Given the crucial importance of banks for the financing of the euro
zone economy and in the ECB’s monetary policy implementation, this situation
was alarming in view of a high risk of a credit crunch and a high risk of the cen-
tral bank’s inability to steer monetary conditions. The ECB, like other major
central banks, rapidly reduced its key interest rates to historically low levels, but
a key element of its response to retain effectiveness in influencing monetary con-
ditions consisted of its non-standard policy measures. The aim was to continue
preserving price stability, contributing to stabilizing the financial situation, and
limiting the fallout on the real economy. As regards interest rate policy, the ECB
cut the main refinancing rate by 50 basis points on October 2008, in a concerted
and historic move with other major central banks; it reduced its key interest rates
further by a total of 325 basis points within a period of 7 months until May 2009.
The main refinancing rate was brought to a historic low of 1%, a level not seen in
euro zone countries in decades.
At the same time, the ECB adopted a number of non-standard measures to
support financing conditions and credit flows to the euro zone economy over
and beyond what could be achieved through reductions in key interest rates
alone (so-called ‘enhanced credit support’). The nonstandard measures imple-
mented from October 2008 onwards were tailored to the specific, bank-based
financial structure of the euro zone, aiming at supporting bank liquidity and
funding. They comprised five key elements, drawing in part on the experience
with non-standard measures during the financial turmoil, which include:
 Fixed-rate full allotment. A fixed-rate full allotment tender procedure
was adopted for all refinancing operations during the financial crisis.
Thus, contrary to normal practice, eligible euro zone financial instituti-

3
ECB, (2010b), ‘The ECB’s Monetary Policy Stance During the Financial Crisis’, Monthly
Bulletin, January 2010, 5.
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48 Nikola Stakiæ
ons have unlimited access to central bank liquidity at the main refinan-
cing rate, as always subject to adequate collateral.
 Extension of the maturity of liquidity provision. The maximum matu-
rity of the longerterm refinancing operations (LTROs) was temporarily
extended (subsequently to 12 months in June 2009). In combination
with the first element, this contributed to keeping money market inte-
rest rates at low levels and increased the Eurosystem’s intermediation
role aimed at easing refinancing concerns of the euro zone banking sec-
tor, especially for term maturities. Reduced liquidity costs and uncerta-
inty and a longer liquidity planning horizon were expected to encourage
banks to continue providing credit to the economy.
 Extension of collateral eligibility. The list of eligible collateral accepted in
Eurosystem refinancing operations was extended, in fact allowing banks
to refinance a larger share of their balance sheet with the Eurosystem.
The ability to refinance less liquid assets through the central bank pro-
vides an effective remedy to liquidity shortages caused by a sudden stop
in interbank lending.
 Currency swap agreements. The Eurosystem temporarily provided liqui-
dity in foreign currencies, at various maturities, and against euro-deno-
minated collateral. For this, the ECB used reciprocal currency arrange-
ments, notably with the US Federal Reserve. A massive shortfall in US
dollar funding was thus avoided: euro zone banks and associated off-
balance-sheet vehicles had significant liabilities in US dollars, having
provided major financing to several US market segments, including real
estate and subprime.
 Covered bond purchase programme (CBPP). The Eurosystem committed
to purchasing covered bonds 4denominated in euro and issued in the
euro zone for a total value of €60 billion gradually over the period
between June 2009 and June 2010. The aim of the programme was to
revive the covered bond market, which is a primary source of funding
for banks in large parts of the euro zone. It is the largest and the most
active segment of the fixed income market alongside the public sector
bond market. Such covered bonds – known as ‘Pfandbriefe’ in Germany,
‘obligations foncières’ in France and ‘cédulas’ in Spain – are long-term
debt securities that are issued by banks to refinance loans to the public
and private sectors, often in connection with real estate transactions.
These covered bonds – unlike mortgage-backed securities – have the
specific legal characteristic of ‘double protection’: recourse to the issuer
as well as additional security provided by the legal pledge of the assets
financed. The size of the programme represented around 2.5% of the

4
http://www.ecb.europa.eu/mopo/liq/html/index.en.html
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 The role and importance of ECB's monetary policy in the global economic crisis 49
total outstanding amount of covered bonds, which in the given context
was effective as a catalyst to restart activity in this market.

4.2. The ECB’s response to the euro zone sovereign debt crisis

In early 2010 the euro zone sovereign debt crisis began with acute market
expectations about a possible Greek sovereign default, with a risk of impact on
Ireland, Portugal, and even Spain and Italy. In May 2010 some secondary mar-
kets for government bonds began to dry up completely; large-scale sale offers
faced virtually no buy orders and yields reached levels that would have quickly
become unsustainable for any sovereign. Given the crucial role of government
bonds as benchmarks for private-sector lending rates and their importance for
bank balance sheets and liquidity operations, this development was considered
to impair the transmission of policy interest rate decisions to the real economy.
To help calm the market down and support a better functioning of the mone-
tary policy transmission mechanism, the ECB established its Securities Markets
Programme (SMP) to ensure depth and liquidity in those market segments that
were dysfunctional. Under the SMP, Eurosystem interventions could be carried
out in the euro zone public and private debt securities markets. In line with Tre-
aty provisions, interventions in sovereign bond markets were strictly limited to
secondary markets. In addition, they were also fully sterilized through liqui-
dity absorbing operations, so as to not affect central bank liquidity conditions.
In alleviating disruptions, the SMP was effective at the outset and led to some
stabilization in markets as well as to an immediate and substantial decline of
government bond yields. Its impact was re-enforced by the parallel announce-
ment on the establishment of a European Financial Stability Facility through
which governments could provide mutual financing support in adjustment pro-
grammes for specific countries.
SMP helped to avoid for some time an uncontrolled increase in sovereign
bond yields and thereby in general financing costs for the economy with adverse
implications for price stability. In addition, it helped to reduce contagion across
countries and thereby shielded monetary policy transmission in large parts of
the euro zone. Other non-standard measures also contributed to dampen the
implications of impairments in the sovereign bond markets. The ECB mitiga-
ted the impact on bank funding through a renewed lengthening in the maturity
of its liquidity provision and through changes in its collateral framework. As
a result, government bonds amounted to less than 20% of the assets deposited
as collateral in Eurosystem operations, compared to close to 30% in 2006. The
remaining 80% included covered bonds, asset-backed securities, or other finan-
cial instruments.

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50 Nikola Stakiæ
5. Conclusion

The current economic crisis, which has entered its sixth year of existence,
has triggered some new mechanism that should respond to the various economic
problems. The combination of deflationary shocks and financial market turbu-
lences has led the central banks to get more actively involved in addressing non-
standard, unconventional measures of monetary policy. The global recession
forced monetary regulators to strictly abide by the policy of low interest rates.
In addition to the reference interest rates, which should serve as the key parame-
ter in the transmission mechanism, what also characterizes these measures are
huge liquidity reserves channeled into the banking sector, purchase of long-term
securities, and direct interventions in certain segments of the financial market.
This paper has reviewed the ECB’s non-standard monetary policy measures
during the global financial crisis and the euro zone sovereign debt crisis. Mone-
tary policy clearly cannot directly address the underlying causes of the crisis and
the associated need for deleveraging by financial and non-financial sectors or
the need for rebalancing within the euro zone. This requires reforms and action
on the part of governments and regulators, individually and collectively, with
respect to fiscal consolidation, structural reforms, financial regulation and the
European governance framework. At the same time, in financial crises central
banks have an important role to play in providing liquidity, averting disorderly
deleveraging and fire-sales of assets, and hence adverse self-fulfilling dynamics,
as well as, more broadly, in safeguarding monetary policy transmission to ensure
price stability .
The ECB’s response to the crisis has, in particular, relied on banks as inter-
mediaries to ensure the continuous financing of households and firms, rather
than intervening in asset markets directly. The rationale of safeguarding mone-
tary policy transmission across the euro zone and addressing dysfunctional
market segments differs from that behind quantitative easing, which is aimed
at providing extra monetary stimulus via outright transactions when the lower
bound for policy rates has been reached.

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 The role and importance of ECB's monetary policy in the global economic crisis 51
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Paper received: January 9th, 2014 Rad primljen: 9. januar 2014.

Approved for publication: January 19th, 2014 Odobren za štampu: 19. januar 2014.

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