(with Zsolt Darvas)
The European Central Bank’s roles have been greatly extended during the crisis, including in fields were it had previously no competences. In a briefing paper written for the European Parliament’s Monetary Dialogue with ECB President Draghi, we look at old and new competences of the ECB, identifying major synergies and conflicts of interests between them.
We do indeed find a number of major synergies. One is between liquidity provision to banks and banking supervision. During the crisis, the ECB provided liquidity to banks at a massive scale under relaxed collateral rules, which was essential to avoid financial and economic meltdown. But at the same time, such operations delayed the bank restructuring efforts, prolonged the existence of non-viable banks, and were at the borderline of back-door financing of public debt, whereby banks borrow cheap from the ECB to purchase government bonds.
The new euro-area architecture has the potential to limit these adverse side-effects: the ECB can foster bank restructuring by performing a tough comprehensive balance sheet assessment before taking over the supervisory role and, after that, micro-prudential supervisory powers can be used to ensure that all banks receiving liquidity support have indeed only a liquidity problem, and not a solvency one. The architecture could be further extended by conditioning longer-term ECB financing on banks not increasing their net lending to the government and/or increasing their net lending to the real economy.
Another major synergy exists between monetary, micro-prudential and macro-prudential policies. Risks can in fact build up in the financial sector even when the price stability mandate is achieved and monetary policy, on its own, is not able to counterbalance such risks. This is especially true in a heterogeneous monetary union like the euro area (see our earlier post on Taylor-rule simulations). Micro- and macro-prudential tools can help to limit the build-up of such risks, leading to synergies. Therefore, the strict organisational separation of monetary policy and bank supervision within the ECB, which seems to be a major goal of SSM regulation, is not so important.
At the same time, there is also a potential for conflicts of interest. An example would be a situation when an interest rate increase is needed for monetary policy purposes but such an increase would have a critical impact on the balance sheet of banks. Another one would be the possibility that monetary policy credibility be undermined by eventual supervisory failures. In our view, these risks are not high and they also do not seem to be shared by markets, given that long-term inflationary expectations continue to be anchored.
There is however one important role that the ECB should give up in our view, i.e. the co-decision on various aspects of financial assistance programmes. While the ECB’s expertise can bring valuable input into design and monitoring, the participation in future assistance programmes – formalised by the Treaty on the European Stability Mechanism (ESM), the permanent Euro-area rescue fund – creates potential conflicts of interest with the other tasks of the ECB. This may bias programme conditionality, expose the ECB to pressure from the other Troika institutions and would make it very difficult for the ECB to conduct a fully independent assessment of conditionality fulfilment. An informal role in the design and monitoring of financial assistance would therefore be preferable.
Finally, there is a dilemma for which no proper solution exists in the euro area’s current economic governance framework: what to do if outright monetary transaction (OMT – the ECB’s government bond purchasing programme) is warranted from a monetary perspective, but the conditionality is not met? The announcement of the OMT was essential to avoid financial meltdown in the euro area, but such a programme cannot be unconditional, as it would create moral hazard and other risks. In case of non-compliance, the ECB would then face the dilemma between (a) interrupting the OMT at the risk of possibly endangering the stability of the euro area, and (b) continuing the OMT at the risk of inflicting a fatal blow to its own credibility. This could also undermine the political support for the euro in creditor countries.
The alternative to this quandary of ‘monetary policy under conditionality’ would be a complete revision of the framework for euro-area sovereign debt crisis management and an immense increase in fiscal integration, by moving toward a system similar to the US, in which state-level public debt is small, there is no federal financial bail-outs for states, the central bank does not purchase state debt and banks do not hold state debt.
Unfortunately, such an immense overhaul of the euro-area architecture is unrealistic in the foreseeable future. So for the time being, we can only hope that the OMT will never be used, but if used, the country in question will comply with the conditionality, sparing the ECB from facing the hard choices.
This article was first published at Bruegel