ZEW discussion paper No 16-019
29 February 2016
Source: Centre for European Economic Research (ZEW)
Viral Acharya, New York University
Diane Pierret, University of Lausanne
Sascha Steffen, University of Mannheim and ZEW
In summer 2011, elevated sovereign risk in Eurozone peripheral countries increased the solvency risk of Eurozone banks, precipitating a run on their short-term debt. We assess the effectiveness of different European Central Bank (ECB) interventions that followed – lender of last resort vs. buyer of last resort – in stabilizing the European financial sector. We find that (i) by being lender of last resort to banks via the long-term refinancing operations (LTRO), ECB temporarily reduced funding pressure for banks, but did not help to contain sovereign risk. In fact, banks of the peripheral countries used the public funds to increase their exposure to risky domestic debt, so that when solvency risk in the Eurozone worsened the run of private short-term investors from Eurozone banks intensified. (ii) In contrast, ECB’s announcement of being a potential buyer of last resort via the Outright Monetary Transaction program (OMT) significantly reduced the bank-sovereign nexus. The OMT increased the market prices of sovereign bonds, leading to a permanent reversal of private funding flows to Eurozone banks holding these bonds.
We assess the effectiveness of unconvential interventions of the European Central Bank (ECB) in restoring financial stability in the Eurozone following the peak of the sovereign debt crisis in summer 2011. A central result of the paper is that how ECB intervened mattered – in particular, whether the ECB acted as lender of last resort (e.g., LTRO in December 2011 and February 2012) or buyer of last resort (e.g., OMT in summer 2012).
While the LTRO did not affect sovereign risk of GIIPS countries, the OMT did significantly reduce the sovereign yields and sovereign credit default swap spreads of Italy and Spain. Moreover, while the LTRO did reduce immediate funding risk for banks, we show that it aggravated the bank-sovereign nexus by giving incentives to GIIPS banks to increase their holdings of domestic sovereign bonds. Consequently, when sovereign risk increased again in the peripheral countries after the LTROs, the financial health of Eurozone banks worsened and the run of short-term private creditors intensified. In contrast, the OMT led to a reduction of the domestic bank-sovereign nexus. By effectively increasing the market prices of sovereign bonds, the OMT gave incentives for all banks to buy these bonds and improved the asset side of banks exposed to GIIPS sovereign debt. The consequence was a permanent reversal of private funding flows towards Eurozone banks following the OMT.
Overall, our findings suggest that the effectiveness of unconventional central bank interventions should not only be assessed in terms of a reduction of immediate funding risk for banks. Instead, we should also carefully assess the effects of these interventions on the asset side of banks. Central bank interventions can aggravate a crisis situation when they increase moral hazard by giving banks incentives to hold onto or expand their holdings of troubled assets. Specifically, without an adequate recapitalization of distressed banks, the lender of last resort interventions can entrench banks with risky assets making them more vulnerable to runs if risky assets worsen in quality. In contrast, buyer of last resort interventions provide liquidity to the market at large and can credibly improve bank fundamentals and stabilize their short-term funding markets.