Foros de la Plataforma por una Vivienda Digna

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Collateral damage

The European Central Bank faces an acute dilemma: on the one hand it needs to ensure that banks have access to adequate liquidity, but on the other it needs to prevent banks profiting unduly from central bank funding. Recent signs of banks undermining the ECB’s generous rules on collateral are worrying, and the ECB should address them promptly. What it cannot afford to do is cause a new storm in the markets. That is easier said than done.

The ECB’s rules on assets acceptable as collateral for banks’ borrowing from the central bank are broader than those of the US Federal Reserve or the Bank of England. During the credit squeeze this has meant that banks have found it easier to obtain liquidity, while at the same time allowing the ECB to keep interest rates high in its fight against inflation. A sudden and significant tightening of rules runs the risk of pushing some banks into liquidation and markets into turmoil.

But the ECB must not allow banks to take unfair advantage of the rules either. While no abuse cases have been made public by the ECB, reports suggest that banks are increasingly using their creativity to benefit. Nationwide is planning to expand into Ireland to make use of the eurozone’s funding opportunities and Australia’s Macquarie had bonds backed by Australian consumer loans accepted as collateral. Spanish banks are scaling up their use of mortgage-backed securities to obtain funding from the ECB – in place of investors willing to take them off their balance sheets.

Not only is it risky for the ECB to sit on assets nobody else wants, it also distorts the market: a true market price for these securities cannot be established if banks have the choice to use the ECB as a dump of last resort.

So broad are the rules that the ECB has a number of options available to tighten them. For example, the ECB could increase the “haircut” – the proportion subtracted from the asset’s market value when used as collateral – or apply additional fees. It could also require higher credit ratings for collateral.

Using price mechanisms such as haircuts and fees to keep moral hazard incentives in check would provide elegant solutions. To limit its own exposure to risk, the ECB could allow only assets issued in the eurozone as collateral, especially since the national central banks in the eurosystem should have a better idea of risks involved.

The ECB has numerous options to be more discriminating about the assets it accepts. Its challenge is to create a framework that differentiates between the opportunists and the needy.
Copyright The Financial Times Limited 2008

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