The European Central Bank is considering a new policy tool that would allow it to inject cash into banks that are being rescued from the threat of insolvency, tackling a gap in rules for dealing with troubled lenders.
The proposal would allow the ECB to fund viable parts of a lender – the so-called good bank -– spun out of a failing financial institution, according to a confidential document obtained by Bloomberg News and based on a March 21 presentation to the ECB’s Governing Council. The suggested framework for Eurosystem Resolution Liquidity (ERL) lays out conditions including a far-reaching guarantee to safeguard against central-bank losses.
The measure is potentially controversial because the ECB is banned by law from financing actions that should be undertaken by public authorities, such as bank resolution. Executive board member Yves Mersch warned in January that "resolution planning should not assume that central-bank liquidity will fill the gaps."
The proposal suggests that ERL should be seen as a monetary-policy tool, ensuring the banking system can transmit official interest rates to the real economy. An ECB spokesman declined to comment on the document.
A new liquidity source has been debated since the Single Resolution Board (SRB), the euro area's bank-failure agency, handled its first big case last June by forcing the sale of Spain's Banco Popular Espanol to Banco Santander. SRB head Elke Koenig has said Santander provided more liquidity than her institution could have done, highlighting the need to find a solution for when the good bank can't immediately find a buyer and has limited or no access to normal sources of liquidity.
“There are a number of scenarios in the context of a resolution in which currently no (additional) liquidity can be provided by Eurosystem central banks,” according to the document. “A permanent framework to provide liquidity in resolution would send a strong signal related to banking union and improve overall confidence in the functioning of the euro-area resolution framework.”
Four proposed rules for granting Eurosystem Resolution Liquidity * The bank has been declared “failing or likely to fail” and the resolution scheme has been adopted:
The bank is formally still eligible as counterparty for Eurosystem monetary policy operations
* The Euro system should benefit from a public-sector guarantee at European level covering the amount of liquidity provided to the bank via ERL
* The Euro system should receive a remuneration set equal to the rate of the marginal lending facility as a minimum and could demand a mark-up
Funding under ERL would require public backing because the requirements for the collateral that banks provide would be weaker than for the ECB’s regular operations. The collateral demand could even be dropped entirely and replaced by the euro-area guarantee in “exceptional circumstances,” according to the proposal.
The guarantee would have to have a “standing character” so that the ECB is able to invoke it “whenever this is deemed necessary.” It should also be provided at the European rather than national level. While that condition is aimed at bolstering the euro area’s attempts to break the interdependence of governments and their nation’s banks, it could run into opposition from Germany and other countries opposed to debt mutualization.
The Governing Council asked for the ECB’s committees to review open issues including ERL’s compatibility with the monetary-policy mandate, as well as collateral requirements and the shape of the public guarantee, according to the document. Staff are due to report back by April 20th.
Open issues also include the relationship to institutions such as the SRB and the European Stability Mechanism, the region’s bailout fund. Under the proposal, either body could provide the guarantee. The Single Resolution Fund, a pot of cash from euro-area banks available to the SRB, could also be required to cover losses from ERL.
The ECB notes in the document that the Bank of England and U.S. authorities already have similar instruments available.
A related topic is Emergency Liquidity Assistance, an instrument which allows national central banks to inject money into lenders that are solvent but running short of cash. It proved controversial during the Greek crisis and most recently after ABLV Bank received fresh liquidity by Latvia’s central bank just hours before being shut down.
ECB President Mario Draghi told European lawmakers in February that ELA should be centralized. A successful implementation of ERL could pave the way for that action to be taken.
The ECB’s proposal may feed into ongoing discussions among the 19 euro members, with leaders determined to make progress on backstopping the SRF as well as implementing a common deposit insurance. Those issues have been difficult to settle amid disagreements over risk-sharing among euro countries.
Mr Mersch’s stance signals that any decision on ERL is unlikely to be imminent though.
“We have not in our mandate to do resolution,” he said on April 3rd in a panel discussion that included Koenig. “We do monetary policy.”