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2023 | OriginalPaper | Chapter

The Cost of Unconventional Monetary Policy Measures. A Risk Manager’s Perspective

Authors : Marco Fruzzetti, Giulio Gariano, Gerardo Palazzo, Antonio Scalia

Published in: Financial Risk Management and Climate Change Risk

Publisher: Springer Nature Switzerland

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Abstract

We examine the evolution of credit risk arising from monetary policy operations and emergency liquidity assistance on the Eurosystem balance sheet over the years 2010–2022. We employ a market-driven risk model relying on the expected default frequencies for sovereigns, banks, and corporates provided by Moody’s Analytics. Dependence between defaults is modelled with a multivariate Student-t distribution with time-varying parameters. We find that at the end of August 2022, shortly after the Eurosystem ended net asset purchases under its long-standing quantitative easing and therefore the balance sheet ceased to grow, risk was approximately equal to less than half of the value measured at the peak of the sovereign debt crisis in 2012, notwithstanding the almost threefold increase in the Eurosystem monetary policy exposure occurred since then. This is due to the launch of the Outright Monetary Transactions Programme and the Pandemic Emergency Purchase Programme, which succeeded in quelling market turmoil, thereby reducing the Eurosystem’s own balance sheet risk. Our findings support the view that, in periods of severe financial distress, sovereign risk for a central bank is largely endogenous.

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For the Eurosystem, the full list includes the Securities Market Programme (SMP), the Very Long-Term Refinancing Operations (VLTROs; see the list of abbreviations at the end of the book), the Targeted Longer-Term Refinancing Operations (TLTROs), the Asset Purchase Programme (APP), and, most recently, the Pandemic Emergency Longer-Term Refinancing Operations (PELTROs) and the Pandemic Emergency Purchase Programme (PEPP). In addition, the Eurosystem has provided USD swap facilities to euro area banks on a regular basis and euro liquidity to non-euro area central banks (EUREP). In the sample period, the Governing Council of the ECB also introduced ‘forward guidance’ on monetary policy decisions in the communication to the public. For a cross-country analysis of the unconventional monetary policy tools, see BIS (2019). For a survey of the literature on the effectiveness of the non-standard monetary policy measures of the ECB, see Neri and Siviero (2019) and Rostagno et al. (2019).

Recurring concerns relate to the following issues: (1) unconventional policies (UPs) may reduce bank profitability (Borio et al. 2015); (2) they may lead to the build-up of asset-price deviations from their fundamentals and trigger a sharp asset-price correction (Borio 2014); (3) UPs may induce financial intermediaries to move toward riskier assets (Rajan 2005; Borio and Zhu 2012); (4) UPs expose monetary authorities to political interference (Taylor 2016); (5) they have undesirable income and wealth redistribution effects (Lenza and Slacalek 2018); (6) they may increase wage pressure, inflation, and undermine the competitiveness of the industry sector (Sinn 2019, 2021); and (7) UPs may cause a slowdown of consolidation and structural reforms on the part of sovereign issuers (Bundesbank 2016). Extreme critics deem the sovereign purchases illegal.

Financial results may be important for a central bank even though it can always create money to pay its bills, it cannot be declared bankrupt by a court, and it does not exist to make profits. Losses or negative capital may raise doubts about the central bank’s ability to deliver on policy targets and expose it to political pressure. Del Negro and Sims (2015) discuss the general conditions under which support from the fiscal authority would be optimal for the central bank policies. The capital strength of the central bank is a key notion in general equilibrium models of the effectiveness of monetary policy regimes (see e.g. Reis 2017; Benigno and Nisticò 2020). Goncharov et al. (2023) examine a large sample of central banks spanning more than 20 years and show that central banks are much more likely to report slightly positive profits than slightly negative profits, especially amid greater political pressure.

Risk originating from the holding of foreign reserves and own funds is not considered.

Draghi (2012) and ECB (2012).

Our evidence is consistent with the argument put forward by Danielsson and Shin (2003), that in normal conditions, when expectations are heterogeneous, market agents are price takers and asset prices only depend on the financial and economic fundamentals, treating risk as exogenous is appropriate. In this case, the use of the standard risk measurement tools, based on the probability densities inferred from past data, is a sound practice. However, when there is a prevailing view concerning the direction of market outcomes and such uniformity leads to broadly similar trading strategies, as occurs during a crisis, the standard risk measurement tools may no longer be adequate. In such circumstances, asset prices not only depend on financial and economic fundamentals but, to a large extent, they are also affected by the response of individual agents to the unfolding events: market distress can feed on itself. When asset prices fall and traders get closer to their trading limits, they are forced to sell. In turn, the selling pressure sets off further downward pressure on asset prices, which induces a further round of selling, and so on (Brunnermeier and Pedersen 2009; Danielsson et al. 2010, 2012).

In particular, with reference to government debt markets, the presence of self-fulfilling defaults is widely studied in the literature. In light of the multiplicity of self-fulfilling equilibria in sovereign debt markets, within a wide range of fiscal fundamentals, the fiscal position of a sovereign may support both equilibria without default and equilibria with default. Calvo (1988) addresses the issue on a theoretical level; see also Cole and Kehoe (2000). de Grauwe (2011), de Grauwe and Yuemei (2012, 2013), Corsetti and Dedola (2016), and Orphanides (2017) apply this notion to the euro area. Reis (2017) shows that quantitative easing can be an effective tool for the central bank during a fiscal crisis, by reducing the sensitivity of inflation to fiscal shocks and preventing a credit crunch.

SMP purchases were conducted by Eurosystem central banks in two main waves. The first one (May 2010 to March 2011) dealt with government bonds from the secondary markets of Greece, Ireland, and Portugal. The second one (which started on 7 August 2011 and ended in February 2012) also dealt with government bonds from Italy and Spain.

Some public information regarding ELA may be found on the website of the relevant NCB. Mourmouras (2017) reports some evidence regarding ELA exposures of the Eurosystem over time. As of May 2017, qualitative information has been provided by the ECB with the publication of the ‘Agreement on emergency liquidity assistance’, a document that describes the allocation of responsibilities, costs, and risks for ELA operations within the Eurosystem (ECB 2017). Calomiris et al. (2016) provide a thorough discussion of the lender-of-last-resort role of the Eurosystem and other central banks.

Moody’s Analytics (2010). The approach is used to derive the 5-year CDS-I-EDFs. The EDFs for different horizons, such as the 1-year horizon that is used in this chapter, are derived from the 5-year ones employing a model of the relationship between credit risk and time horizons that relies on three components: an asymptotic default tendency, a systemic factor and a firm-specific factor (see Moody’s Analytics 2017 for further details).

When deriving default probabilities from market prices (equity prices, bond yield spreads, CDS premia), it is important to distinguish between physical and risk-neutral default probabilities. While risk-neutral default probabilities adjust for investors’ risk aversion, physical default probabilities, which can be thought of as ‘real world’ default probabilities, do not. Market prices, including CDS premia, reflect the expected loss—equal to the product of the probability of default (PD) times the loss given default (LGD)—and the risk premium, but frequently PDs extracted from market prices fail to remove the risk premium, thus largely overstating actual default rates, especially among higher rated entities. Moody’s EDF measures are physical PDs; since they filter out the premium demanded by investors to compensate for risk inherent in the CDS contract, they reflect only the risk of the underlying credit. See Hull et al. (2005).

The credit claims accepted as collateral under the Additional Credit Claims (ACC) regime belong to this category.

While distinct EDFs are available for central governments and local governments, we only consider central government EDFs, which we apply to local government issues as well.

After the first 50,000 simulations, we estimate risk by adding 10,000 scenarios at a time and we stop the simulation when the change in the estimated risk is below 1% for five consecutive times.

Potential losses arising from market prices movements are therefore not considered.

This takes into account the fact that purchase programme holdings are not marked-to-market.

See Moody’s (2021a, b).

Since our analysis focuses on default risk, the market risk of collateral (i.e. the possibility that its price goes down during the liquidation process) is not considered.

Excluding cash collateral (if any), since it does not carry risk.

In principle, this approach could lead to an underestimation of EAD as well, since banks could also decide to increase their collateral pool (i.e. to pledge more assets). However, such a hypothesis would require an estimation of eligible unencumbered assets for each counterparty, which is difficult to obtain.

Our distribution is symmetric. Caballero et al. (2020), which use a similar dataset to calibrate a skewed t copula, argue that the introduction of an asymmetric term has a small effect on the expected shortfall estimates.

In principle, purchase programme holdings with maturity below one year should be simulated over a horizon equal to their maturity. We do not take this into account, which seems acceptable if one considers the practice of reinvestment which has taken place until the end of the sample period.

As otherwise it would imply perfect correlation within cluster: Σ_{cluster(i),cluster(j)} = Σ_c,c = 1.

More specifically, we test an alternative estimation based on the changes in normal quantiles of the EDF indices, which is another common transformation (the normal quantile of the probability of default is sometimes referred to as distance-to-default).

In the first quarter of 2018 Spain were upgraded from BBB to A by both Fitch and S&P.

Figure 8 does not show the breakdown for confidentiality reasons.

The individual NCB figures are not provided for confidentiality reasons.

Garcia-de-Andoain and Kremer (2018) and Holló et al. (2012).

ECB (2010a).

It was made very clear that ‘the ECB was not printing money’, the purchases made on the secondary market were ‘not meant to help Governments to circumvent the fundamental principle of budgetary discipline’ and, even more importantly, purchases would be decided by the Governing Council at its discretion (ECB 2010b).

Fairly soon, bond traders learned about the ECB’s actual presence in the market under SMP. As evidence accumulated about the likely size and time profile of the official interventions in the distressed jurisdictions, investors grew concerned that the programme might fall short of the minimum scale that, in their assessment, would be necessary to decisively eradicate the fear that was gripping the sovereign bond market (Rostagno et al. 2019). At the press conference following the Governing Council meeting of 10 June 2010, in response to a question about the size and jurisdictions of purchases, President Trichet replied: ‘You could see that the first week we withdrew approximately 16.5 billion euros, the second week 10 billion more, the third week an additional 8.5 billion, in the fourth week 5.5 billion. So you have this information. We withdraw exactly the level of liquidity that we inject. No other indication’.

ECB (2011).

After the August 2011 decision, the spread between 10 year Italian and German government bond yields decreased from around 400 basis points to 270 basis points. This positive market reaction was short lived and the spread climbed to 500 basis points at the beginning of November 2011 and again in January 2012.

Draghi (2012). The irreversibility of the euro made the premia on sovereign bonds (owing to the so-called convertibility risk) unwarranted, as they derived from the wrong perception that a sovereign in financial difficulty would abandon the euro and return to its domestic currency. To the extent that the size of these sovereign premia was hampering the functioning of the monetary policy transmission channel, addressing them was in the remit of the ECB.

ECB (2012). Although the operational details would have been communicated over the following weeks, during the Q&A session with journalists, it was made clear that the new programme would have been ‘very different from the previous Securities Market Programme’. The following aspects were mentioned: (1) explicit conditionality; (2) full transparency about the countries where OMT would be undertaken and about the amounts; (3) focus on the shorter part of the yield curve; and (4) review of the issue of the seniority of the Eurosystem claims.

Altavilla et al. (2016) find evidence that the OMT announcement significantly lowered yield spreads of sovereign bonds, especially for stressed euro area countries. Acharya et al. (2018) and Krishnamurthy et al. (2017) show significantly positive effects on banks’ equity prices after the OMT announcement.

These diverging views were explicitly acknowledged on 6 September 2012 during the press conference in which the President of the ECB announced the details of the OMT.

For an analysis of the macroeconomic effects of the APP in counteracting the falling inflation expectations, see Neri (2021).

The complainants—a group of about 1750 people, led by German economists and law professors—first brought their case in 2015. They argued that the ECB was straying into monetary financing of governments, which is illegal under the EU treaty. The case was referred to the European Court of Justice, which ruled in favor of the ECB in 2018; the case went back to the German constitutional court, which on 5 May 2020 formally rejected the plaintiff’s case (there was no monetary financing) but ruled the essential aspects of PSPP to be unconstitutional under German law.

ECB (2020a). On 3 March, the Federal Reserve lowered the target range for the federal funds rate by 0.5 percentage points (to 1–1.25%) and the discount rate from 2.25 to 1.75%.

ECB (2020b).

Time-wise flexibility allows the central bank to adjust the pace of asset purchases to market conditions. Bernardini and Conti (2021) show that this type of flexibility in the implementation of the programme significantly contributed to its effectiveness.

ECB (2020c). The ECB also said it ‘may decide, if and when necessary, to take additional measures to further mitigate the impact of rating downgrades, particularly with a view to ensuring the smooth transmission of its monetary policy in all jurisdictions of the euro area’. Investors were particularly concerned by a potential downgrade of Italy’s sovereign debt ratings, with Standard & Poor’s set to announce a decision about that on Friday 24 April 2020. S&P later confirmed the rating and the negative outlook.

It is also worth recalling the unexpected downgrade of Italy’s credit rating by Fitch Ratings late on 28 April and the German Federal Court ruling that the PSPP partly violates the German constitution on 6 May 2020. The latter made it highly likely that German critics of the ECB would challenge the PEPP, too.

ECB (2022a).

The moments of the Student distribution are undefined for low values of the degrees of freedom parameter (for example, the variance is defined only for a number of degrees of freedom above 2).

Own-used assets are those assets for which issuer and counterparty are either the same or have close links. Currently, only covered bonds are accepted as own-used collateral.

The credit claims accepted under the Additional Credit Claims regime fall under this second category.

By ABS, we mean ‘senior tranches of ABS’, which are the only type of ABS eligible as collateral and for purchases.

Covered bonds and ABS have almost always an AA rating.

For covered bonds, we use the ‘Global Corporates’ default rates, since no covered bonds default was ever experienced in the past. For ABS, we use the ‘Structured Finance’ default rates.

CBPP1&2, SMP, CBPP3, ABSPP, PSPP, CSPP, PEPP-Covered, PEPP-Public, PEPP-Corporate.

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Title: The Cost of Unconventional Monetary Policy Measures. A Risk Manager’s Perspective
Authors: Marco Fruzzetti
Giulio Gariano
Gerardo Palazzo
Antonio Scalia
Publisher: Springer Nature Switzerland
Book: Financial Risk Management and Climate Change Risk
Print ISBN: 978-3-031-33881-6

Electronic ISBN: 978-3-031-33882-3

Copyright Year: 2023
DOI: https://doi.org/10.1007/978-3-031-33882-3_2