Alternative monetary policy tools of the ECB: Impact on financial markets

Abstract

This thesis investigates the four firstly applied alternative monetary policy measures that the ECB announced in order to deal with the financial crises: fixed rate full allotment procedure (FRFA), longer-term refinancing operations (LTROs), foreign exchange liquidity provision (FEL), and easing of collateral (EOC). The aim of the paper was to answer two research questions: 1) Why did the ECB find it necessary to use alternative monetary policy measures? 2) Did these measures manage to achieve their purpose? The ECB started using non-traditional measures as increasing tensions in the money markets did not allow normal monetary policy transmission mechanisms to work. Before the crises, the ECB conducted open-market operations at a specified minimum bid rate (MBR), which together with the reserve requirements and standing facilities allowed achieving balanced liquidity conditions. In the middle of 2007, this became impossible due to the following reasons: a) the ECB lost control of steering the Euro Overnight Index Average rate (Eonia), which became increasingly volatile. In order for the transmission to work, the ECB needs Eonia to be quite close to the MBR. b) The spread between key money market indices increased significantly. Namely, the spread between the Euribor different maturities and between Euribor and Eoniaswap increased significantly. c) The spread between the marginal rate (the lowest successful bid rate) and the minimum bid rate became unpredictable. The ECB needs it to be stable in order to make qualified decisions about liquidity needs. The purpose of the empirical analysis was to estimate if the alternative policy tools managed to ease some of the money market tensions, by focusing on the spreads mentioned under point b). That was achieved by measuring financial market reaction on the days when the ECB made key announcements about the four alternative policy tools. The expected results were decreasing money market spreads and increasing stock market indices. The latter would show the market’s approval of the use of these measures. Impact on exchange rates was also tested, since changes in the latter may influence investments and economic growth. Using the GARCH (1,1) and Least Squares models, the estimation results were the following: First, majority of the announcements managed to decrease the Euribor-Eoniaswap spreads. Thus, the news of these measures decreased liquidity and/or credit risk premium on the money markets. At the same time, the spreads between Euribor shorter and longer maturities mostly increased. The latter result is contrary to the expected, since despite the unlimited liquidity provision measures for shorter and longer term maturities, the Eurosystem Panel Banks demanded increased risk premium on the interbank lending markets. Second, stock markets experienced large drops on majority of the key announcements days. This may indicate disapproval on the use of these measures, or instead, increasing fears about further deepening of the crises.