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ISSUE 2013/13OCTOBER 2013 THE EUROPEAN

CENTRAL BANK IN THEAGE OF BANKING UNION

ZSOLT DARVAS AND SILVIA MERLER

Telephone+32 2 227 [email protected]

www.bruegel.org

BRUEGELPOLICY CONTRIBUTION

Highlights During the crisis the European Central Banks roles have been greatly extended

beyond its price stability mandate. In addition to the primary objective of price sta-bility and the secondary objective of supporting EU economic policies, we identifyten new tasks related to monetary policy and financial stability.

We argue that there are three main constraints on monetary policy: fiscal domi-nance, financial repercussions and regional divergences. By assessing the ECBstasks in light of these constraints, we highlight a number of synergies between thesetasks and the ECBs primary mandate of price stability.

But we highlight major conflicts of interest related to the ECBs participation in finan-cial assistance programmes. We also underline that the ECBs government bondpurchasing programmes have introduced the concept of monetary policy underconditionality, which involves major dilemmas. A solution would be a major changetowards a US-style system, in which state public debts are small, there are no fede-ral bail-outs for states, the central bank does not purchase state debt and banks donot hold state debt. Such a change is unrealistic in the foreseeable future.

Zsolt Darvas ([email protected]) is a Senior Fellow at Bruegel.Silvia Merler([email protected]) is a Bruegel Affiliate Fellow. This paper was prepared forthe European Parliament Economic and Monetary Affairs Committee ahead of the Euro-

pean Parliaments Monetary Dialogue with ECB President Mario Draghi on 23 Septem-ber 2013. The paper benefited from comments and suggestions from FrancescoPapadia, Guntram B. Wolff and other Bruegel colleagues, for which the authors are gra-teful. Copyright remains with the European Union at all times.

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BANKING UNIONZSOLT DARVAS AND SILVIA MERLER, OCTOBER 2013

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BRUEGELPOLICY CONTRIBUTION

1. Additional tasks includeforeign-exchange opera-

tions, foreign reserve man-

agement, operation of thepayments system, advisoryfunctions, collection of sta-

tistical information andinternational cooperation.

INTRODUCTION

Before the crisis, the European Central Bank (ECB)focussed on price stability and gained a strongreputation as its guardian in the euro area. Theaverage actual inflation rate was very close to thetwo percent per year target, and long-term infla-tionary expectations were anchored at this level.With the start of the global financial and economiccrisis in the summer of 2007 and the intensifica-tion of the euro crisis in early 2010, the ECBstasks have been significantly extended, partly atits own initiative, and partly by legislation adoptedby EU member states, in relation to monetarypolicy and beyond.

The ECB adopted wide-ranging measures to sup-port financial stability and repair the monetarytransmission mechanism, by providing banks withample liquidity under revised collateral rules andby launching two government bond purchasingprogrammes. The latter programmes introducedthe concept of monetary policy with conditional-ity. The ECB conducted two small-scale quantita-tive easing programmes (purchasing of coveredbonds) to promote credit growth. The ECB becamea member of the Troika, along with the EuropeanCommission and the IMF, and as a consequence it

has been actively involved in the design and mon-itoring of the economic conditionality in the con-text of EU/IMF macroeconomic adjustmentprogrammes in euro-area countries. Such compe-tences for the ECB have been formalised andbroadened by the Treaty on the European Stabil-ity Mechanism (ESM), the euro areas permanentrescue fund. The ECB started to take on boardmacro-prudential roles by becoming a key partic-ipant in the European Systemic Risk Board (ESRB).Also, the ECB agreed to act as an agent for the sec-

ondary market activities of the European FinancialStability Facility (EFSF) and the European StabilityMechanism (ESM), the rescue funds of the euroarea, and it can play a role in surveillance mis-

THE EUROPEAN CENTRAL BANK IN THE AGE OF BANKING UNIONDarvas & Merler

sions within the Macroeconomic Imbalances Pro-cedure (MIP).

Most of these tasks and roles will remain perma-nent and major new tasks are being addedbecause of the development of the Single Super-visory Mechanism (SSM), the first element of theEuropean Banking Union. This will probably be thebiggest change in the history of the ECB and willgive it both micro-prudential and macro-pruden-tial competences. Before assuming the day-to-day supervisory role, the ECB will have to conducta comprehensive asset-quality review of thosefinancial institutions that will fall under itsumbrella.

Beyond taking stock of the ECBs new tasks, thisPolicy Contribution assesses the possible syner-gies and conflicts of interests between these var-ious tasks. It is important to emphasise that ourgoal is not the evaluation of the ECB's response tothe crisis; instead, we take a forward-looking per-spective to assess the interaction between vari-ous ECB tasks. We first describe the tasks in thenext section. This is followed by a discussion of the three main potential constraints to the effec-tive implementation of monetary policy. After that,we assess the possible synergies and conflicts.

The final section offers some conclusions.

1 TWELVE TASKS FOR THE ECB

Based on its mandates as defined in the Treaty onthe Functioning of the EU (TFEU) and in other Euro-pean legislation, the ECB has several tasks in theeuro area, some of which have implications fornon-euro area EU countries. Among the varioustasks we highlight the twelve that are the most rel-evant for monetary policy and financial stability1.

Task 1: Maintaining price stability

The core monetary function of the European

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BRUEGELPOLICY CONTRIBUTIONDarvas & MerlerTHE EUROPEAN CENTRAL BANK IN THE AGE OF BANKING UNION

2. We note that in July 2013the ECB added a major newelement to its communica-tion strategy: forward guid-

ance, which is a way forcentral banks to give indica-

tions about their futurepolicy intentions, by

making it more (like the FEDand the BOE) or less (likethe ECB) explicitly condi-

tional on the assessment of the current and future eco-nomic developments and

outlook.

3. For detailed reviews of the ECB crisis responses,

see Cour-Thimann andWinkler (2013) and ECB

(2011a).

4. For a very detailed reviewof the legal technicalities of

the ELA see Boyer andLemangnen (2013).

banks (Pisani-Ferry and Wolff, 2012a), at a timewhen the interbank market had become dysfunc-

tional and several countries in the south of theeuro area were undergoing a sudden stop in exter-nal financing (Merler and Pisani-Ferry, 2012a). InOctober 2008, the ECB introduced a policy of fullallotment, for all ECB liquidity-providing opera-tions. Under this procedure, the control of centralbank liquidity is effectively moved from the cen-tral bank to the banking system, as banks canaccess all the central bank liquidity they need ata fixed rate (if they priovide sufficient eligible col-lateral). The maturity of liquidity operations wereinitially extended from three months to six andtwelve months, and in December 2011 and in Feb-ruary 2012 the ECB also conducted two extraordi-nary Longer Term Refinancing Operations (LTROs)with maturities of three years, from which banks inthe euro area borrowed almost 1 trillion. Theseoperations, along with the collateral policy (seebelow) allowed liquidity-strained banks to refi-nance a large portion of their balance sheetsthrough central bank lending, available at a lowinterest rate and long-term maturity. In a heavilybank-based system, such as the euro areas(Darvas, 2013a), these measures were essentialto avoid financial and economic meltdown.

Another crucial element during the crisis wasEmergency Liquidity Assistance (ELA), an emer-gency liquidity line provided by national centralbanks to solvent banks that exceptionally andtemporarily do not have enough (or sufficientlyhigh quality collateral) to access normal Eurosys-tem operations. The ECBs Governing Council canat any time order an ELA programme to be

stopped4. The ELA statistics are opaque, yet mostlikely the central banks of Greece, Ireland andCyprus have used ELA extensively, while it wasused for a few days in Belgium. Recent rumourssuggest that Portugal also made use of ELA.

Task 4: Collateral policy

Complementing its credit operations, the ECB haschanged its collateral framework several times

System of Central Banks (ESCB), which is gov-erned by the decision-making bodies of the ECB, is

laid down in Article 127(1) of the TFEU, accordingto which:The primary objective of the European System of Central Banks [...] shall be to maintain price stability . The numerical definition of pricestability (below but close to 2 percent inflationover the medium-term ) is not laid down in theTreaty, but was set by the ECBs Governing Council.

In pursuing its task to preserve price stability, theECB acts in full independence from any EU insti-tutions, bodies, offices and agencies and frommember state governments. In normal times, themain tools for achieving price stability are interestrate policy, short-term liquidity management andcommunication2.

Task 2: Supporting EU economic policies

Article 127(1) of the TFEU continues by statingthat Without prejudice to the objective of pricestability, the ESCB shall support the general eco-nomic policies in the Union with a view to con-tributing to the achievement of the objectives of the Union . The latter are listed in Article 3 of theTFEU and includeinter alia balanced economic growth and a highly competitive social marketeconomy, aiming at full employment and social progress .

The specific price-stability mandate and theserather broad other Treaty-based mandates pavedthe way for the ECB to venture into unconventionalmonetary policy during the global and euro-areacrises3. Most of the measures are still operational

and could remain in the toolkit for some time.

Task 3: Lender of last resort for banks

Unlike the Federal Reserve (Fed), the Bank of Eng-land (BOE) and the Bank of Japan (BOJ), whichrelied extensively on asset purchase interven-tions, the ECBs unconventional monetary opera-tions have been mostly concentrated on ensuringthe necessary supply of liquidity to euro-area

The price-stability mandate and the other Treaty-based mandate to support the general eco-nomic policies in the EU paved the way for the ECB to venture into unconventional monetary

policy during the crisis, which was essential to avoid financial and economic meltdown.

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5. Cour-Thimann and Winkler(2013) estimate that the

size of the first programmerepresented about 2.5

percent of the outstandingcovered bonds.

6. De Sousa and Papadia(2013) estimate that the

SMP would have been aprofitable operation undermark to market acounting.

7. Seewww.consilium.europa.eu/uedocs/cms_data/docs/press

data/en/ec/113563.pdf.

since 2008, expanding and changing assetseligibility requirements in order to mitigate

possible constraints arising from collateralshortage. It is worth mentioning that certain creditclaims have been included among eligiblecollaterals. Also, while initially the ECB denied theneed for country-specific collateral rules, credit-rating requirements were completely abolishedfor government bonds of countries under financialassistance programmes.

Task 5: Quantitative easing: targeted credit easingthrough asset purchases

The ECB introduced two asset purchase pro-grammes though at a much smaller scale thanthe Fed, BOE and BOJ. Under the first Covered BondPurchase Programme (CBPP), launched in 2009and terminated in June 2010, the Eurosystemcommitted to buy covered bonds up to 60 billion,while in November 2011 the second CBPP com-mitment was up to 40 billion until October 20125.The goals of these programmes were(a) easing funding conditions for credit institutions andenterprises; and (b) encouraging credit institu-tions to maintain and expand lending to their clients .

Task 6: Sterilised government bond purchases

The ECB launched two government bond purchas-ing programmes: the Securities Market Pro-gramme (SMP) on 10 May 2010, which on 6September 2012 was terminated and replaced bythe Outright Monetary Transactions (OMTs). Whilemonetary financing of governments is strictly pro-

hibited, Article 18(1) of the ESCB Statute allowsnational central banks and the ECB to buy or sell(among others) marketable instruments on thefinancial markets. Both programmes had similaraims: the SMPsobjective is to address the mal- functioning of securities markets and restore anappropriate monetary policy transmission mech-anism and the OMTsaim at safeguarding anappropriate monetary policy transmission and thesingleness of the monetary policy. In the frame-work of the SMP, the Eurosystem bought on the

secondary market about 220 billion of the sov-ereign bonds of Greece, Ireland, Portugal, Italy andSpain. At the end of 2011, the ECBs holding wasestimated to amount to about 23 percent of total

outstanding in Greece, 16 percent in Ireland, 11percent in Portugal, 6 percent in Italy and 5 per-

cent in Spain (Merler and Pisani-Ferry 2012b)6

. Allthe purchases were sterilised (ie the liquidity pro-vided was re-absorbed by the Eurosystem) toensure that the monetary stance was not affected.The SMP could not bring definitive relief to mar-kets, while the OMT has to date been more suc-cessful (see Darvas, 2012). It is based on explicitconditionality: compliance with a full or precau-tionary macroeconomic adjustment programmeby either the European Financial Stability Facility(EFSF) or the European Stability Mechanism(ESM). Countries exiting current adjustment pro-grammes could also be considered. ECB interven-tion will not be automatic, but the GoverningCouncil will decide on a case-by-case basis whenand to what extent it will intervene. OMTs will beunlimited in principle; limited only by the out-standing stock of eligible bonds, which shouldhave residual maturity of between one and threeyears (the relevant horizon for monetary trans-mission). The ECB will not have any preferentialtreatment in the case of a credit event (ie pari passu treatment with other creditors). Since theprogramme's inauguration, no country has quali-fied for OMT.

Task 7: Designing, approving and monitoringfinancial assistance programmes

The Troika of the IMF, the EU and the ECB was inau-gurated in spring 2010 to negotiate the Greekfinancial assistance programme. The participationof the ECB, and of the IMF, was demanded by theheads of state or government in their 25 March

2010 statement7. The Troika also negotiated thefinancial assistance programmes for Ireland, Por-tugal and Cyprus, and the new programmes forGreece, and concluded joint missions to assesscompliance.

The ESM Treaty formalises the ECBs role in cover-ing the whole process of granting and monitoringfinancial assistance programmes.TheEuropeanCommission, in liaison with the ECB, shall beentrusted with several tasks, such asassessing

the existence of a risk to the financial stability of the euro area as a whole or of its Member States; Assessing whether public debt is sustainable; Assessing the actual or potential financing needs

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of the ESM Member concerned (Article 13(1)),...the task of negotiating, with the ESM Member

concerned, a memorandum of understanding [...]detailing the conditionality attached to the finan-cial assistance facility (Article 13(3)), andmon-itoring compliance with the conditionalityattached to the financial assistance facility (Arti-cle 13(7)). Wherever appropriate and possible, theIMFs involvement will be sought.

When emergency voting is needed, itshall beused where the Commission and the ECB bothconclude that a failure to urgently adopt a deci-sion to grant or implement financial assistance[...] would threaten the economic and financialsustainability of the euro area (Article 4).

The ECB will be also involved in forming an opin-ion on other aspects of ESM operations, includingpossible secondary market support:decisions oninterventions on the secondary market to addresscontagion shall be taken on the basis of an analy-sis of the ECB recognising the existence of excep-tional financial market circumstances and risksto financial stability (Article 18).

Task 8: Micro-prudential supervision

Arguably, the most significant change to the ECBsstructure has been brought about by the decisionto give to it significant supervisory responsibilitiesin the framework of the Single Supervisory Mech-anism (SSM), which is the first element of theEuropean Banking Union. The legal basis is pro-vided by Article 127(6) of the TFEU:The Council,acting by means of regulations in accordance

with a special legislative procedure, may unani-mously, and after consulting the European Parlia-ment and the European Central Bank, confer specific tasks upon the European Central Bankconcerning policies relating to the prudentialsupervision of credit institutions and other finan-cial institutions with the exception of insuranceundertakings .

After extensive negotiations between various

stakeholders, on 12 September 2013 the Euro-pean Parliament gave its consent with the

amended draft Council Regulation on conferringthe aforementioned tasks with a view to con-tributing to the safety and soundness of creditinstitutions and the stability of the financialsystem within the EU and each Member State (Article 1 of the Regulation).

Starting in Autumn 2014, the ECB will supervisesignificant credit institutions (as defined by theregulation; see eg Darvas and Wolff, 2013), andwill have exclusive competence for thosespecificsupervisory tasks which are crucial to ensure acoherent and effective implementation of theUnion's policy relating to the prudential supervi-sion of credit institutions . Such tasks include inparticular: authorising (and withdrawing authori-sation) of credit institutions; assessing the impli-cations for the acquisition and disposal of qualifying holdings in credit institutions (exceptin cases of bank resolution); ensuring compliancewith the EU rules on own funds requirements,securitisation, large exposure limits, liquidity,leverage, and reporting and public disclosure of information on those matters; ensuring compli-ance with governance rules, risk managementprocesses, internal control mechanisms, remu-neration policies and practices and effective inter-nal capital adequacy assessment processes;carrying out supervisory reviews, including stresstests, on the basis of which to impose on creditinstitutions specific requirements; carrying outsupervisory tasks in relation to recovery plans,and early intervention where a supervised entitydoes not meet or is likely to breach the applicable

prudential requirements.

Task 9: Comprehensive balance-sheet assessment

Related to assuming the role of the single super-visor, the ECB should performa comprehensiveassessment, including a balance-sheet assess-ment, of the credit institutions (Article 27(4) of the SSM draft regulation), before actually takingon the new supervisory responsibilities. We high-

Arguably, the most significant change to the ECBs structure has been brought about by thedecision to give to it significant supervisory responsibilities in the framework of the Single

Supervisory Mechanism, which is the first element of the European Banking Union.

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light this role, because this is a major task that willlikely have an impact on the reputation of the ECB

for its supervisory mandate and beyond.

Task 10: Macro-prudential supervision

The ECBs macro-prudential tasks are related to theEuropean Systemic Risk Board (ESRB) and theSSM.

The ESRB was set up in 2010, gathering represen-tatives from national central banks and supervi-sors from all EU countries. The ESRB became partof the European System of Financial Supervision(ESFS) and it will be required to cooperate closelywith the other participants in the ESFS8. The ESRB,according to its mandate,shall be responsible for the macro-prudential oversight of the financialsystem within the Union in order to contribute tothe prevention or mitigation of systemic risks to financial stability [...] that arise from develop-ments within the financial system and taking intoaccount macro-economic developments, so as toavoid periods of widespread financial distress.The ESRB was not given any direct authority overpolicy instruments, but it has the power to issuerecommendations and warnings about systemicrisks to national authorities. The decision-makingbody of the ESRB, the General Board, is chaired bythe president of the ECB. The ESRB Secretariat islocated at the ECB.

The SSM Draft Regulation provides a role for boththe ECB and national supervisors in macro-pru-dential policy, under the principle of the strongerwins. While the ECB can express objections to

measures proposed by a national authority, theauthority concerned only has toduly consider theECBs reasons prior to proceeding with the deci-sion (Article 4a(1)). The ECB cannot block suchmeasures. On the other hand, the ECB is given thepower to apply higher requirements for capitalbuffers and more stringent measures than thoseset by the national authorities, with the aim of addressing systemic or macro-prudential risks.And again the ECB is only obliged toduly con-sider the objections of national supervisor, if any,

but these objections do not have blocking power.It is important to highlight that the macro-pruden-tial tools available to the ECB will be more limitedthan the arsenal available to national supervisors.

National supervisors can applyany [other]measures aimed at addressing systemic or

macro-prudential risks provided for, and subjectto the procedures set out, in the Directives2006/48/EC and 2006/49/EC , but the ECB canonly applyhigher requirements for capital buffers... in addition to own funds requirements ... includ-ing countercyclical buffer rates . Therefore, theECB can apply those tools seeking to influencelenders behaviour, as categorised by Blanchard,DellAriccia and Mauro (2013), but the ECB cannotapply tools aimed at controlling borrowers behav-iour, such as loan-to-value ratios and debt-to-income ratios.

Task 11: Possible participation in macroeconomicsurveillance missions

The so-called six-pack, which governs the EUsnew Macroeconomic Imbalances Procedure (MIP),foresees a possible role for the ECB in macroeco-nomic surveillance missions. Article 9 of Regula-tion No 1176/2011 dealing withMonitoring of corrective action says that: The Commissionmay carry out enhanced surveillance missions tothe Member State concerned, in order to monitor the implementation of the corrective action plan,in liaison with the ECB when those missions con-cern Member States whose currency is the euro....Article 13(3) clarifies the role of the ECB in thesesurveillance missions:Where the Member Stateconcerned is a Member State whose currency isthe euro or is participating in ERM II, the Commis-sion may, if appropriate, invite representatives of the European Central Bank to participate in sur-veillance missions.

Therefore, it seems that the ECB will have only alow profile in macroeconomic surveillance mis-sions, but no specific tasks and responsibilitiesare related to such missions, nor to other ele-ments of the MIP process.

Task 12: Agent for the secondary market activitiesof the ESFS and ESM

In December 2011, the ECB agreed to act as an

agent for the secondary market activities of theEFSF and the same role is foreseen for the ESM9.The ESCB statute allows such operations (underthe prohibition of overdraft or any other kind of

8. As well as the ESRB, theESFS comprises: the Euro-

pean Banking Authority(EBA), the European Insur-

ance and Occupational Pen-sions Authority (EIOPA), the

European Securities andMarkets Authority (ESMA),the Joint Committee of the

European SupervisoryAuthorities (ESAs), and thecompetent or supervisoryauthorities in the memberstates as specified in the

legislation establishing thethree ESAs.

9. See question 36 on page

19 of the Frequently AskedQuestions on the ESM:http://www.esm.europa.eu/ pdf/FAQ%20ESM%2001072

013.pdf

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credit facilities). In this role, the ECB would merelyexecute the EFSF/ESMs decisions on secondary

market operations.

All in all, beyond the primary objective of price sta-bility, the ECB has a Treaty-based mandate to sup-port the EU's broader goals related to growth,competitiveness, employment, social progress,the soundness of credit institutions and financialstability, while the ESM Treaty broadened theresponsibilities of the ECB in financial assistanceprogrammes. The ECBs role in macroeconomicsurveillance will have a low profile, while it canalso act as the agent of the EFSF and ESM on thesecondary government bond markets.

2 MONETARY POLICY CONSTRAINTS

There are at least three main constraints on mon-etary policy, which all have a bearing on theassessment of the various tasks of a central bank:fiscal dominance, financial repercussions andregional divergences. We highlight these con-straints before assessing the ECBs tasks in thenext section.

Fiscal dominance

Fiscal dominance describes a situation in whichthere is a threat to fiscal sustainability due to largepublic debt and budget deficit, potentially endan-gering financial and macroeconomic stability. Thislimits the freedom of the central banks (eitherindirectly by internalising the threat from fiscalunsustainability, or directly by pressure from thegovernment) in pursuing the price-stability goal

freely. The central bank can influence governmentborrowing costs in various ways and under fiscaldominance it may act to help fiscal sustainability,to the detriment of its core price stability mandate.

Financial repercussions

Financial sector vulnerability is a key constraint.The period in the run-up to the global financial andeconomic crisis has clearly indicated that pricestability (defined as low and stable inflation) in

itself is insufficient to promote stable and durableeconomic growth. On both sides of the Atlantic,major financial vulnerabilities were built up, whicherupted suddenly, leading to major economic con-

tractions, high unemployment and undershootingof the inflation target during the crisis. In Europe,

banking fragility continues to constrain monetarytransmission even five years after the demise of Lehman Brothers.

Regional divergences

Regional divergences, such as the build-up of macroeconomic imbalances (diverging externalpositions and price competitiveness) were partic-ularly notable in the euro area, where there is nocentralised fiscal authority to smooth regionalshocks, and where intra-regional adjustmentmechanisms work much less effectively than infederal states, like the United States. Particularlyweak economic conditions in some regions of amonetary union, in the absence of proper adjust-ment mechanisms, undermine the one size fitsall property of monetary policy (Figure 1 on thenext page, panels B, C and D). But the vicious circlebetween banks and sovereigns (whereby bankshold a large amount of the debt of the governmentof their home country and are expected to bebailed out by the same government) in someeuro-area countries further pushed both banksand governments to the abyss, thereby leading tomajor differences in the transmission of monetarypolicy across the members of the euro area. Whileat the present economic juncture the optimal rateswarranted for, eg Spain (and also for a number of other euro-area countries), would be much lowerthan in Germany, actual lending rates are muchhigher in Spain, partly because of the fragmenta-tion of euro-area financial markets, and partlybecause of higher risks and weaker economic out-

look in Spain, which in turn are related to the build-up of the pre-crisis macroeconomic imbalances.Therefore, macroeconomic imbalances canhamper the proper transmission of the ECBs mon-etary policy.

3 SYNERGIES AND CONFLICTS BETWEEN THEECBS TASKS

The key take-away from the previous section isthat the conditions for proper conduct of monetary

policy across the regions of a monetary union aresound public finances, sound banks and financialstability and balanced economic development. Weassess the various tasks assigned to, or adopted

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by, the ECB in light of this lesson. There are sev-eral interactions between the ECBs task. Here wefocus on five issues that we regard as most impor-tant, starting with the easiest to solve, and endingwith the most difficult.

Long-term liquidity operations: easy to remedythe dangers

In normal times, central banks did not engage inreally long-term liquidity operations (recall thatbefore the crisis, the maturity of ECBs LTROs wasthree months). A reason for this is related to moral

hazard: long-term central bank financing at ratesbelow what banks could get from the market mightencourage excessive risk taking. Also, such oper-ations may keep alive otherwise insolvent banks.The ECBs 3-year LTROs reduced the risk that sol-vent banks could become insolvent because of liquidity constraints, and it also contributed,though only temporarily, to the stabilisation of Ital-ian and Spanish government bond markets (see

Darvas and Savelin, 2012), which was a majorachievement at that time. But they did little to trig-ger lending to the private sector. To a great extent,banks either deposited the cheap central bank

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(A) Euro area aggregate (B) Intra-euro area diversity of Taylor rule recommendations

(C) Intra-euro area diversity of Taylor rule recommendations

(D) Intra-euro area diversity of Taylor rule recommendations

Figure 1: Taylor rule recommendations for the ECB interest rate, 1999Q1-2013Q3

Source: Bruegel using the methodology of Mechio (2011). Notes: Taylor rule target = 1 + 1.5 x inflation 1 x unemploymentgap. Similarly to Mechio (2011), we use core inflation (all items HICP excluding volatile food and energy prices) and the devia-tion of the actual unemployment rate from the estimated non-accelerating inflation rate of unemployment (NAIRU), as esti-mated by the OECD. MRO = Main refinancing operations. The 2013Q3 recommendation is based on July-August 2013 inflationrate and the July 2013 unemployment rate. The countries are ordered according to the average absolute deviation from the

euro-area recommendation in 1999-2013, ie developments in France were the closest to the euro-area average and Ireland wasthe farthest from the euro-area average. See Darvas and Merler (2013) for a more in-depth discussion of this figure.

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funding at the ECB for rainy days, or purchasedhigher yielding government bonds. Thereby, the

LTROs in effect supported liquidity, ensured stablelong-term (3-year) financing, subsidised the bank-ing system and helped to restore profitability, andtemporarily supported distressed governmentbond markets. When the alternative was a poten-tially escalating financial crisis, these achieve-ments were beneficial.

But Belke (2012) and Pill (2013) rightly argue thatthe LTROs delayed the bank restructuring effortsand prolonged the existence of non-viable banks,with major negative side effects.The remedies forthis are obvious: the ECB can foster bank restruc-turing by performing in the toughest possible waythe comprehensive balance-sheet assessment(task 9 in section 2) before it takes over the singlesupervisory role. After that, the ECB's micro-pru-dential supervisory powers (task 8) should beused to ensure that all banks receiving liquiditysupport have indeed only a liquidity problem, andnot a solvency problem.

This is even more relevant in the context of theELA, where the dividing line is less clear and wherethe pressure is the highest, because the impact of a decision for or against the granting of emergencyliquidity can have significant financial stabilityconsequences. The case of Cyprus, where theexistence of major banking problems was proba-bly known well before the dramatic days in March2013 (when banks were closed down for severaldays and uninsured depositors suffered massivelosses), but where ELA was provided to banks ona massive scale, is exemplary in this respect. Fur-

thermore, to dispel all doubts that liquidity provi-sion to banks is back-door financing of public debt(whereby banks borrow cheap from the ECB topurchase government bonds), longer-term ECBfinancing could be conditioned that banks do notincrease their net lending to the governmentand/or increase their net lending to the real econ-omy (see Darvas, 2013b).

Monetary, micro- and macro-prudential policies:good siblings

There is a potential synergy between monetary,micro-prudential and macro-prudential policies, ietasks 1, 8 and 10 (section 2). As we argued, risk

may be building up in the financial sector andasset prices deviate upward from fundamental

levels even without significant movement in CPIinflation. The potential for monetary policy to reactwould be limited in that case, because monetarypolicy does not take asset prices into account butgenerally targets consumer-price inflation. On theother hand, low interest rates, which are neededto stimulate demand in an economic downturn,may encourage excessive risk taking by the finan-cial sector, which could be counteracted by strongmicro-prudential supervision and macro-pruden-tial tools (Farhi and Tirole, 2012).

The synergy between these policies can be evenstronger in a heterogeneous monetary union, likeEMU, in which there are divergences in inflationdynamics at the regional (or country) level. Thecounteractive role of monetary policy is evenmore limited in this case, because the centralbank targets the average inflation rate. As Blan-chard et al (2013) argue, in such a heterogeneousunion, macro-prudential tools have to contributeto the management of aggregate demand too.

Yet as Blanchardet al (2013) highlight, the keyquestions is the organisation of these policies:should they belong to a single institution or inde-pendent institutions? We agree with their conclu-sion that when none of them works perfectly,combining them in the same institution bringsmore benefits than possible costs.

Certainly, there are associated risks. For example,a main argument against giving the same institu-tion both price and financial stability mandates is

that the latter might undermine the former: whenmonetary policy considerations may necessitateincreasing the interest rate, the merged institutionmay be reluctant to raise interest rates, if it endan-gers financial stability, and therefore the inflationrate may overshoot the target. At least so far, thisrisk is not shared by market participants, as thefive-year ahead inflationary expectations in theeuro area continue to be anchored to the two per-cent target, even though more recently the ECBssupervisory role became a certainty (Figure 2 on

the next page).Another main risk would be reputational. The pos-sibility of supervisory failures or, more generally,

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of negative events occurring within the remit of banking supervision, cannot be excluded, and therisk is that any blow to the central bank as super-visor could negatively spill over to the credibility of the central bank as the guardian of price stability(Goodhart, 2000).

An additional risk pointed out by Goodhart (2000)is the possibility that the central bank could loseindependence and become politically captured,by taking up a role that is particularly sensitivefrom a political perspective. It could be argued thatthe SSM structure can potentially mitigate this riskwith respect to a decentralised system, by bring-ing national supervisors together and subjectingthem to a certain degree of peer pressure.

Overall, the risk that the ECBs financial supervi-sory role may undermine its monetary policy does

not seem too high.

There is a synergy between micro-prudentialsupervision and the assessment of risk to thefinancial system as a whole, which falls within themacro-prudential remit of the ECB. Informationabout the financial system including at the insti-tution-level is a crucial variable for the effectiveconduct of macro-prudential policy.

Concerning the macro-prudential tools available

to the ECB, their limitations may constrain effec-tiveness. The ECB cannot impose, for example,limitations on loan-to-value ratios. This is a majorshortcoming, because housing is a very important

source of macro risk and housing bubbles havefrequently been associated with financial crises.

The national supervisory authorities will havesuch tools: it will to be seen if national supervisorswill be as vigilant as the ECB in pinpointing hous-ing bubbles. While the housing sector is typicallypolitically sensitive, it would have been better toentrust the ECB with direct tools to include thissector.

One way to circumvent this limitation would be toinvolve the ECB more in macroeconomic surveil-lance. As highlighted by task 11 in section 2, theECB will have negligible role in the MacroeconomicImbalances Procedure, which is also designed toidentify similar vulnerabilities.

More generally, to the extent that the evolution of the financial cycle which is generally agreed tobe the target of macro-prudential policy can bedriven by the development of underlying macro-economic imbalances in the economy, theinvolvement of the ECB in the field of macroeco-nomic surveillance seems complementary to theconduct of macro-prudential competences that ithas been assigned.

Overall, we regard it a wise decision to entrust theECB with micro- and macro-prudential compe-tences, yet the limitations to the ECBs macro-pru-dential tools may constrain effectiveness.

Monetary policy and bank supervision: internalseparation within the ECB to be reconsidered

The draft SSM Regulation requires as much sepa-

ration as possible of financial supervision frommonetary policy within the ECB. But is this sepa-ration needed? We highlighted some points infavour of separation in the previous section andconcluded that they are not decisive.

Also, there is not a unanimous agreement in theliterature on whether the two functions should bekept separate (see Beck and Gros, 2012, for anoverview of the literature). It is not unusual forcentral banks to be in charge of supervisory

responsibility. Fourteen out of the seventeennational central banks in the euro area have a rolein supervision and so do several major centralbanks elsewhere in the world (Draghi, 2012).

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Figure 2: Euro-area ination: actual andexpected, December 1998 to June 2013

Source: ECB. Note: percent change compared to the samemonth of the previous year, using the harmonised index of consumer prices. Expectations: ECB Survey of ProfessionalForecasters.

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10. In their final agreementbefore the 12 September

2013 vote of the EuropeanParliament, EP President

Martin Schulz and ECB Pres-ident Mario Draghi agreedover transparency, under

which the ECB will send

detailed confidentialaccounts of the minutes of its bank supervisory board

meetings.

11. For an extensive evalua-tion of the Troikas operate

and set-up see Pisani-Ferry,Sapir and Wolff (2013). Pre-

liminary assessments of the specific role played by

the ECB and of the potentialconflicts of interest for the

central bank had been con-

ducted also by Merler,Pisani-Ferry and Wolff (2012). This section is

largely based on these twoworks.

There can be significant synergies between mon-etary policy and supervision. ECB president Draghi

himself has stressed thatit is an established factthat stronger supervision facilitates the conductof monetary policy (Draghi, 2012). One reasonfor this is that the banking system plays a crucialrole in the transmission of monetary policyimpulses to the economy and therefore in theachievement of the central banks goal. This isespecially the case in times of crisis, when thebanking system comes under heightened stress,the monetary transmission mechanism can beimpaired and the standard monetary policy tools(the short-term interest rate) can become power-less. This synergy constitutes a rationale for thecentral bank to have an interest in the stability of the financial system (Constncio, 2013) andtherefore in its effective supervision, as the lattercontributes to a stable financial system [and]can only benefit the smooth transmission of mon-etary policy (Draghi, 2012). Therefore, if it is truethat in crisis times the line between (unconven-tional) monetary policy and financial supervisionbecomes less clear, it is also true that in such a sit-uation output and inflation are subject to down-side risks, and financial stability and price stabilityactions would go in the same direction, making aconflict unlikely.

Also, as we concluded at the start of this section,using supervisory information will help the ECB indeciding which banks are solvent but illiquid, andwhich banks are insolvent, which would be essen-tial for its function as the lender of last resort tobanks. As pointed out by Whelan (2012), theexperience with Northern Rock in 2007 shows

how coordination of different authorities can beinsufficient to solve the problems associated withthe lender of last resort not being involved insupervision. The fact that the removal of bankingsupervision from the Bank of England decidedin 1997 is now being reversed, can perhaps betaken as a sign that strictly separating bank super-vision and monetary policy may be suboptimal.

A more practical question is if a full organisationalseparation of the two functions within the ECB is

possible. The Supervisory Board will consist of fiverepresentatives of the ECB and potentially the rep-resentatives of all euro-area central banks. Aspointed out by Beck and Gros (2012), it is very dif-

ficult to imagine how national central bank repre-sentatives could not be in very close contact,

especially since one (the governor) would be hier-archically superior to the other (the head of super-vision). The final decision will anyway remain withthe Governing Council, even though the latter issupposed to operatein a completely differenti-ated manner when dealing with monetary policyand with supervision. But it would be the samepeople deciding and it is hard to see how theywould not use all the information at their disposal,when taking a decision.

It is also noteworthy that in the Bank of England,such a separation was not sought:

The new system ... encourages co-opera-tion and co-ordination across the different policy bodies. [...] There is overlap between thememberships of the FPC, the PRA Board and theMPC, including the Governor and the DeputyGovernor for Financial Stability both beingmembers of all three policymaking bodies. Thiswill support the flow of information across thedifferent bodies and an understanding of their approaches and likely reactions to events (BoE 2013, page 26).

Certainly, the ECB is accountable in different waysfor monetary policy and financial supervisorydecisions, and the European Parliament rightlyrequested more detailed information about super-visory decisions10. But it would be not too difficultto ensure that supervisory decisions are moretransparent for the Parliament even when there isgreater information sharing within the ECB

between the two areas.

We therefore conclude that the efforts made in thedraft SSM regulation to separate monetary policyand financial supervision within the ECB may nothave been so important.

Designing and monitoring of financial assis-tance programmes: a dangerous liaison

The role played by the ECB in the Troika is ambigu-

ous11

and difficult to assess. The local central bankis always included in negotiations on IMF financialassistance programmes, but since the centralbanks of programme countries in the euro area are

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part of the Eurosystem, the ECB could not havebeen left out. However, the ECB sits on the same

side of the table with lenders (IMF and the Euro-pean Commission), while in a typical IMF pro-gramme, the central bank of a country with its owncurrency would sit with the national authorities.

There are three additional reasons for ECB involve-ment (Pisani-Ferry, Sapir and Wolff, 2013). First,the European leaders trusted the ECB and wantedit to be part of the European negotiation teamalongside the Commission. Second, Europeanleaders feared possible recommendations fromthe IMF that would have challenged ECB policiesand therefore wanted to make it possible for thecentral bank to participate in the policy discus-sions. Third, the ECB had a very significant expo-sure to programme countries (through its liquidityoperation with banks) without having any legalhold over the supervisory assessment of its bank-ing system. Participation in the Troika gave to theECB the possibility to perform a better assessmentof potential risks to its balance sheet, and to havea say over decisions that might affect it.

All of these reasons will likely characterise futureESM programmes. But the ECBs participation inthe design and monitoring of financial assistanceprogrammes creates potential conflicts of interestwith the other mandates of the ECB.

First, there is a potential conflict with the ECBsprime activity of monetary policy, and in particu-lar, price stability. In the implementation phase of programmes, the ECB might be tempted to deviatefrom its price stability objective in order to help

improve fiscal sustainability in a given programmecountry. Ex ante, the fear that fiscal unsustain-ability in a particular country might result in pres-sure on the central bank to soften its monetarystance might lead the ECB to overemphasise theneed for fiscal consolidation. However, it shouldbe stressed that this problem is not specific to theparticipation of the ECB in the Troika, becausefiscal dominance coming from non-programmeeuro-area countries can also undermine the price

The ECBs participation in the design and monitoring of financial assistance programmes cre-ates potential conflicts of interest with its other tasks, which may bias programme conditional-

ity and exposes the ECB to pressure from the other Troika institutions.

stability mandate (see section 3). In this context,we note that fiscal sustainability in larger euro-

area countries, such as Italy and Spain, provides agreater threat to financial stability than fiscal sus-tainability in current programme countries (whichare all much smaller). Therefore irrespective of theECBs participation in the Troika, it may be temptedto opt for higher inflation than the target.

The experience so far has clearly demonstratedthat this is not the case, even though Greek publicdebt became unsustainable and so far two roundsof public debt restructuring have been imple-mented. On the contrary, the major risk at themoment is that inflation undershoots the target inthe coming years (even the ECBs own forecast for2013-14 is well below the target), while the ECBdoes not act to counterbalance it. This will makethe adjustment of countries in southern Europemuch more difficult, because when average euro-area inflation undershoots the two percent target,the conflict between intra-euro relative priceadjustment and debt sustainability is more severe(Darvas, 2013c).

Second, there is a potential conflict of interest withthe ECBs function of lender of last resort to banks.Banks in programme countries are typically underhigh stress and may need to rely heavily on ECBliquidity.Ex ante, the ECB might seek to minimiseliquidity operations that constitute a risk to its ownbalance sheet, and to label banking problems assolvency problems that would need to beaddressed through state bail-out or through bail-inof private shareholders and creditors.Ex posthowever, the ECB might actually be inclined to

provide liquidity on soft terms, as would anycentral bank interested in the success of theprogramme, by acting on the strictness of itscollateral framework or of the ELA provision. Again,this possible conflict is not specific to financialassistance programmes, as the ECB may actsimilarly with respect to non-programmecountries. But the ECBs participation in the designof financial assistance programmes may biasprogramme conditionality.

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Third, there is a potential conflict of interest withthe ECBs bond-purchase programmes. By buying

bonds of vulnerable countries in the context of theSMP or OMT, the ECB becomes formally a creditorof the governments receiving financial assistance,and this may influence its position in the negotia-tions. Fear of losses stemming from its bond hold-ings might lead the ECB to be especially tough onfiscal consolidation or especially timid on debtrestructuring if the latter were needed toreduce the likelihood of losses on its holdings. TheGreek case, in which the ECB loudly rejected debtrestructuring even a few weeks before such a deci-sion was made by euro-area heads of state, andthen negotiated a special position so that ECBholdings of Greek government bonds were notrestructured, clearly underlines this threat. Also,a highly problematic issue with respect to theECBs OMT is the introduction of an explicit condi-tionality set-up in the conduct of monetary policy,which is particularly delicate and dangerous, andis dealt with in the next section.

In conclusion, the unclear nature of the ECBshybrid role in the Troika raises concerns aboutpossible conflicts of interest that the ECB couldexperience in relation to the conduct of its otherfunctions. This role, which the ECB took on in emer-gency at the time of the first Greek programme, isnow being crystallised into a permanent compe-tence by the ESM Treaty (see task 7 in section 2).The ECB will have a say both ex ante, in the pre-liminary assessment of the decision to grant sup-port, and ex post, in the monitoring of conditionality, thus being in the delicate positionof having to balance considerations of financial

and fiscal stability.

A better option would have been a light participa-tion of the ECB in financial assistance pro-grammes, such as voicing concerns, beyondobtaining information, which is in line with theconclusions of Pisani-Ferry, Sapir and Wolff (2012). However, this option is not feasible with-out a change to the ESM Treaty.

Monetary policy with conditionality: major

dilemmas

Government bond purchases by the ECB, whichreduce the yields and increase the price of gov-

ernment bonds, can help the transmission of mon-etary policy through three main channels (see

ECB, 2012a):

1 Price channel: excessive government bondyields increase the yields for the private sector,because government yields are typically takenas a benchmark, and therefore a reduction inthe government bond yield reduces the yieldsfor the private sector;

2 Balance-sheet channel: government bond pur-chases can lead to a fall in government bondyields/increase in the price of governmentbonds, which improves bank balance sheetsand thereby the ability of banks to lend to thenon-financial sector, because they hold signif-icant amounts of government bonds;

3 Liquidity channel: pressure on the sovereignbond markets makes it substantially more dif-ficult for banks to access liquidity on the inter-bank market, when government bonds areused in repo markets as collateral and as abenchmark for the haircut applied to otherinstruments. Government bond purchases bythe ECB can reduce such pressure.

While these benefits and their link to monetarypolicy transmission are straightforward, and it isfair to say that without the SMP and OMT the euroarea would have likely been engulfed by a finan-cial meltdown, there are number of concerns withECB government bond purchases:

a Even if purchases are conducted on the sec-ondary market, they are on the borderline withdebt monetisation. There may be investors who

purchase bonds on the primary market onlybecause they know that they can sell thesebonds to the ECB on the secondary market,thereby they intermediate the ECBs second-ary market purchases to the primary market.

b Such an implicit debt monetisation may endan-ger the ECBs reputation.

c The ECB may suffer losses in the event of sov-ereign default.

d Moral hazard: by reducing the market pressureon the beneficiary countries, the bond-buying

programme would simultaneously reduce theincentives to consolidate and reform.

The ECB itself seems to have anticipated the latter

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concern and made it very clear in the announce-ment of the SMP that the Governing Council, in

making its decision, hadtaken note of the state-ment of the euro area governments that they[would] take all measures needed to meet [their] fiscal targets [that] year and the years ahead inline with excessive deficit procedures and of the precise additional commitments taken by someeuro area governments to accelerate fiscal con-solidation and ensure the sustainability of their public finances 12.

Certainly, the policies adopted by governmentshave a bearing on the effectiveness of the actionsof central banks. But the fact that the SMPannouncement formally refers to governmentsfiscal commitments raises important issues. First,it suggests that a decision taken in the remit of monetary policy had been to some extent subjectto fiscal considerations despite the ECB notbeing a fiscal policy-making institution. Second,although the tone is vague enough not to estab-lish any direct link (taken note ), the statementstill seems to convey the message that withoutsuch commitments, the ECB might have acted dif-ferently. Since the SMP was subject to the full dis-cretion of the Governing Council, the result seemsto be a sense of embryonic (and implicit) condi-tionality: the ECB adopts measures to improvemonetary transmission, and thereby achieve itsTreaty-based primary objective of price stability,only if governments do their homework.

The existence and the risks of such informalconditionality became clear in August/September2011, when the ECB started to buy Italian bonds.

It was not publicly disclosed at the time, butbefore engaging in the Italian bond market the ECBhad sent a dry letter to Rome, listing a number of measures that the ECB consideredessential forItaly at that juncture. No explicit reference wasobviously made to the SMP and the actions listedin the letter were not described as conditions forits activation. But the possibility that the ECB couldintervene to ease the escalating tensions on theItalian bond market had been extensively dis-cussed over the summer and the ECB started

buying Italian government bonds a few days afterthe letter was sent.

The intervention was successful in easing the

pressure on Italian sovereign bonds (at least inthe short term), but by the end of the month the

Italian government publicly announced the inten-tion to scrap a previously proposed solidarity tax.For those critics of the SMP who had been warningagainst the risk of moral hazard, this was a night-mare coming true: the ECB had provided relief frommarket pressure to a country whose governmentwas now backtracking on its commitments.

The OMT framework marks a shift to an entirely dif-ferent level, in two respects. First, it introducesexplicit conditionality for the bond buying, whichis made subject to the activation of an ESM/EFSFprogramme. Second, and most important, itassigns to the ECB an equally explicit and activerole in the monitoring and assessment of compli-ance with such conditionality, thus blurring evenmore the thin red line between monetary andfiscal policy and increasing the potential for con-flicts of interests.

This setting puts the ECB in an extremely delicateposition. In the words of ECB president MarioDraghi, the objective of the OMT is tosafeguardthe monetary policy transmission mechanism inall countries of the euro area. [...] to preserve thesingleness of [...] monetary policy and to ensurethe proper transmission of our policy stance to thereal economy throughout the area . As such, itqualifies as a tool fully within the ECBs monetarypolicy scope. At the same time, however, it is amonetary policy instrument, the activation anduse of which is made subject to considerationsthat would not strictly pertain to a central bank inthe exercise of its monetary policy competences.

The ECB explicitly commits to terminate the OMTnot only as would be logical in case the latteris no longer warranted from a monetary policy per-spective, but also in case the beneficiary countryfails to comply with the required conditionality.

It therefore introduces an idea of monetary policywith conditionality. As Nielsen (2012) points out,this idea is quite unheard of and not easily justifi-able from a theoretical perspective, not to mentionthat it creates confusion about the ECB action. The

specific way in which this conditionality is struc-tured is indeed problematic not just for the ECBsindependence, but also for the survival of the euro.

12. ECB press release:http://www.ecb.int/press/pr/ date/2010/html/pr100510.

en.html.

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1 First, it is unclear how compliance with the con-ditionality would be assessed. The ECB will be

involved, with the European Commission andpossibly the IMF, in future ESM-funded finan-cial assistance programmes, according to theESM Treaty (see task 7 in section 2). This wouldmake it very difficult for the ECB to conduct afully independent assessment of conditional-ity fulfilment and it could expose it to pressurefrom the other institutions, even if the Govern-ing Council will decidein full discretion 13.

2 Second, in a case in which the OMT was war-ranted from a monetary perspective, but theconditionality was not met, the ECB would facethe dilemma between (a) interrupting the OMTat the risk of possibly endangering the stabil-ity of the euro area, and (b) continuing the OMTat the risk of inflicting a fatal blow to its owncredibility. The latter could also undermine thepolitical support for the euro in creditor coun-tries. The choice would be a very tough one, andconsequences could be dismal in either case.

There are no easy solutions to this quandary and,in our view, this is the most problematic dilemmathat the ECB faces.

A possible though imperfect solution could beto remove the ECBs own assessment of thefulfilment of the conditionality, and also to removethe ECBs contribution to the ESMs assessment.In turn, the latter would require changes to theESM Treaty, as we discussed in the previoussection. Therefore, the decision on compliancewith the conditionality would be based solely onthe ESM Board of Directors, and the ECB would

need to assess only if the OMT is warranted from amonetary policy perspective, if the ESM Board of Directors gives the green light. In such a system,the responsibility for starting, and once started,stopping or continuing the OMT when complianceis either not met or on the borderline, would liewith the Governors of the ESM Board, ie therepresentatives of euro-area governments, whohave, in the first place, created a financialassistance system in the euro area. This is

because in uncertain situations when complianceis at question, markets will likely behave

nervously and therefore there would be a need foran OMT from a monetary policy perspective.

On the other hand, such a system would under-mine the ECBs monetary policy independence,because it would make it possible for monetarypolicy measures to be taken based on the deci-sions of a body other than the Governing Council.Also, leaving the decision on compliance entirelyto a more political body is not without risks. TheECB is in a privileged position to assess the finan-cial risks facing member states and the euro area.ESM Governors would not be able to have thesame information on their own, and if they receivethis information from the ECB in an informal way,they may not take it sufficiently into accountwhen making decisions that can have politicalrepercussions. ECB involvement in the assess-ment of compliance is therefore problematic andvaluable at the same time. Excluding it entirelyfrom the process of evaluating financial assis-tance programmes may not be the best way tosquare the circle.

Consequently, there is no correct solution to theaforementioned dilemmas. When members of amonetary union have large public debts, a lenderof last resort for governments is necessary toavoid a bad equilibrium in which financial marketsforce an otherwise solvent country into default(De Grauwe, 2011). This cannot be unconditional,as it would create moral hazard. But as the experi-ence of the SMP indicates, informal conditionalitydoes not work, while formal conditionality

exposes the ECB to the major dilemmas discussedin the two points above.

The best we can hope is that the OMT will neverneed to be used, but if used, the country in ques-tion will comply with the conditionality.

The alternative to the OMT would be to revise com-pletely the framework for euro-area sovereign-debt crisis management, by moving toward a

In a case in which the OMT was warranted from a monetary perspective, but the conditionalitywas not met, the ECB would face a dilemma between interrupting the OMT at the risk of endanger-

ing euro-area stability, and continuing the OMT at the risk of a fatal blow to its own credibility.

13. The technical featuresof the OMT regulate the

assessment the followingway:The Governing Coun-

cil will consider OutrightMonetary Transactions to

the extent that they are war-ranted from a monetary

policy perspective as longas programme conditional-

ity is fully respected, andterminate them once their objectives are achieved or when there is non-compli-

ance with the macroeco-nomic adjustment or

precautionary programme.Following a thorough

assessment, the GoverningCouncil will decide on the

start, continuation and sus- pension of Outright Mone-

tary Transactions in fulldiscretion and acting inaccordance with its mone-tary policy mandate (ECB,

2012).

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US-style system, in which state-level pubic debtis small, there is no federal financial bail-out for

states, the central bank does not purchase statedebt and banks do not hold state debt. Under suchconditions, markets would discipline state publicfinances well and an eventual default of a stategovernment would not undermine financial sta-bility. Since public debts in most euro-area coun-tries are high, steps toward such a system shouldinvolve a much higher level of fiscal integration,including the mutualisation of a significant shareof public debt (like the Blue bonds of vonWeizscker and Delpla, 2010). Holding theremaining national debt (Red Bonds) could beprohibited for banks, or at least higher capitalrequirements could apply. This would reduce theimpact of a sovereign default on the country itself and reduce contagion fears (Darvas, 2011). How-ever, by drawing a parallel with US history,ORourke and Taylor (2013) remind us that evenafter the US political integration, it took a very longand painful process to reach a high level of fiscalintegration. It is unfortunately unrealistic for theeuro-area to embark on such an immense changein the foreseeable future.

4 CONCLUSION

After gaining a strong reputation as the guardianof price stability in the euro area, the EuropeanCentral Banks roles have been greatly extendedduring the crisis, taking in monetary policy andother areas. The good news is that the new taskshave not endangered (at least so far) the ECBsability to anchor the inflation expectations of market participants: five-year-ahead expectations

continue to be anchored at the two percent target.

Nevertheless, the new tasks pose major chal-lenges for the ECB and give rise to both synergiesand conflicts of interests. We have reviewed thenew tasks and assessed five major interactionsbetween them.

First, while liquidity provision to banks at a mas-sive scale can stabilise financial markets in astress situation, it can keep alive otherwise insol-

vent banks, encourage excessive risk taking andindirectly finance governments (when banksborrow cheaply from the ECB to purchase govern-ment bonds). The new EMU architecture has the

potential to limit these adverse side-effects: theECB can foster bank restructuring by performing

in the toughest possible way the comprehensivebalance sheet assessment before it takes over thesingle supervisory role and, after that, micro-pru-dential supervisory powers can be used to ensurethat all banks receiving liquidity support haveindeed only a liquidity problem, and not a sol-vency problem. The architecture could be furtherextended to dispel all doubts that liquidity provi-sion to banks is backdoor financing of public debt:longer-term ECB financing could be conditional onbanks not increasing their net lending to the gov-ernment and/or increasing their net lending to thereal economy.

Second, there is a potential synergy betweenmonetary, micro-prudential and macro-prudentialpolicies. Risks can build up in the financial sectoreven when the price stability mandate isachieved; monetary policy, on its own, is not ableto counterbalance such risks. This is especiallytrue in a heterogeneous monetary union like theEMU. Micro- and macro-prudential tools can helpto limit the build-up of such risks, leading to syn-ergies. But there is a potential for conflicts of inter-est too, for example, in a situation when aninterest rate increase is needed for monetarypolicy purposes but such an increase would havea critical impact on the balance sheet of banks.Monetary policy credibility may also be under-mined by eventual supervisory failures. In ourview, these risks are not high and also not sharedby markets, because long-term inflationary expec-tations continue to be anchored. We also note,however, that the limitations on the ECBs macro-

prudential tools (eg the ECB cannot imposerequirements for loan-to-value ratios) may con-strain effectiveness.

Third, the strict organisational separation of mon-etary policy and bank supervision within the ECB,which was a major goal of SSM regulation, is notso important. On the contrary, because of syner-gies between monetary policy and financialsupervision, an appropriate flow of informationwould facilitate the achievements of the goals of

price and financial stability, even if the trans-parency and accountability requirements of mon-etary policy and supervisory decisions aredifferent. Recent organisational changes at the

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Bank of England also encourage co-operation andco-ordination across the different policy areas.

Fourth, the roles played by the ECB in financialassistance programmes as a partner of the Euro-pean Commission and the IMF in the Troika isambiguous. The ECBs participation in future assis-tance programmes, which is formalised by thetreaty on the European Stability Mechanism, cre-ates potential conflicts of interest with the othertasks of the ECB, such as price stability, liquidityprovision to banks and the new bond purchasingprogramme, the Outright Monetary Transactions(OMTs). While the ECBs expertise could bring valu-able input into programme design and monitoring,the conflicts of interest may alter the ECBs posi-tions and could be exposed pressures from theother institutions of the Trokia. An informal role inthe design and monitoring of financial assistancewould lessen the possible conflicts of interests.

Fifth, the ECBs government bond purchasing pro-grammes were essential to avoid financial melt-down in the euro area. But this cannot beunconditional, as it would create moral hazard andother risks. The informal conditionality of the Secu-rities Markets Programme did not work and theformal conditionality of the OMTs exposes the ECB

to a major dilemma: if the OMT is warranted from amonetary perspective, but the conditionality is not

met, the ECB would face the dilemma between (a)interrupting the OMT at the risk of possibly endan-gering the stability of the euro area, and (b) con-tinuing the OMT at the risk of inflicting a fatal blowto its own credibility. This could also underminethe political support for the euro in creditor coun-tries. On top of this dilemma, the involvement of the ECB in the negotiation of an EFSF/ESM pro-gramme within the Troika would make it very diffi-cult for the ECB to conduct a fully independentassessment of conditionality fulfilment and itcould expose it to pressure from the other institu-tions. There is no proper solution to this quandaryof monetary policy under conditionality withinthe euro areas current economic governanceframework. The alternative to the OMT would be acomplete revision of the framework for euro-areasovereign debt crisis management and animmense increase in fiscal integration, by movingtoward a system similar to the US, in which state-level public debt is small, there is no federal finan-cial bail-outs for states, the central bank does notpurchase state debt and banks do not hold statedebt. Unfortunately such an immense change forthe euro area is unrealistic in the foreseeablefuture.

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