FT Alphaville " About that broken ECB transmission mechanism... Readers might recall that FT Alphaville spent a good portion of 2011 speculating about whether the ECB had lost control of the policy transmission mechanism. Our point specifically related to the ECB's diminishing influence on the secured collateral financing market, and how Target2 imbalances were potentially compromising its influence further. A new presentation from Benoît Coeré, ECB board member, now picks up on that very theme. There's no reference to the role of Target2, mind you, but plenty of discussion about the impaired policy transmission mechanism and how it had to be fixed via liquidity channels. Indeed, as Coeré notes (our emphasis): Among fixed-income securities, government bonds are very important for three reasons. First, low liquidity and uncertain prices for government bonds have a degrading effect on the value and acceptability of collateral which is used in secured finance. The growing role of secured lending in financial markets means that financial intermediation would suffer enormously from any paralysis in sovereign bond transactions. Second, sharply lower bond prices can cause significant losses in the portfolios of financial and non-financial institutions. For banks, this would reduce their ability to provide loans to the economy. Third, interest rates on government bonds influence the level of interest rates that firms have to pay when issuing their bonds and that banks use to price their loans. Government bond yields are the basis for the pricing of all assets, from fixed-income instruments to equity. The decision to intervene was a decision to support the discovery of prices in markets which are key to transmitting our policy intentions and which had become highly dysfunctional. As tensions grew in the summer and autumn of 2011, we strengthened our response further. See slide 20. In our first three-year longer-term refinancing operation in December last year we provided around €489 billion of stable funding to 523 banks in the euro area. In the second one - conducted on 29 February this year - we supplied €530 billion to 800 banks. Both long-term credit operations aimed to break a vicious circle in which sovereign funding stress impedes bank access to longer-term financing and ultimately disrupts the flow of credit to households and companies. It's worth noting that the second operation reached a much wider group of banks - among them many small banks providing funds specifically to small and medium-sized enterprises. Its effect was heightened by an expanded range of collateral, which particularly facilitated the participation of small and medium-sized banks. Importantly, risks related to the expansion of collateral have been mitigated by stringent risk control measures. For instance, the haircuts on additional credit claims are very high so as to make the riskiness of these additional credit claims about the same as that of the rest of the collateral, for which the haircuts are lower. We are confident that wider participation by banks can lead to a broader dissemination of credit to small and medium-sized borrowers. He goes on to explain that the LTRO thus specifically took aim at the liquidity channel - a measure which was linked to resolving the dysfunctions in the bond markets. But it was never the ECB's intention to influence what he calls the "d" factor - credit default risk. That's to say, ECB bond purchases and collateral-backed refinancings were never designed to paper-over or disguise the credit default risk which was out there. The "d" factor originates elsewhere, outside the monetary policy sphere of influence. It is not the role of the ECB to cure the root cause of the malaise: weak fiscal institutions and concerns about fiscal sustainability, reinforced by diverging competitiveness among euro area countries and low growth potential in a wide range of countries due to delayed structural reforms. Monetary policy is not and cannot be a substitute for sustainable fiscal policies, structural reforms and adequate governance. These policies are indeed in the remit of governments. The question is, has the move to address the impaired mechanism via liquidity channels, been enough to regain control? From the way key funding rates have reacted thus far, seemingly yes: Related links: The bund that broke the Bundesbank - FT Alphaville A loser's nightmare in Europe's debt auctions? - FT Alphaville One Eurobond to rule them all - FT Alphaville On the ECB's "most significant non-standard measure" - FT Alphaville This entry was posted by Izabella Kaminska on Wednesday, March 28th, 2012 at 8:24 and is filed under Capital markets. Tagged with Benoit Coeré, collateral, ecb, LTRO, transmission mechanisms.