Risk management and monetary policy: a veritable balancing act!
A balancing act
All economic agents need to find the right balance between profitability and risk. The search for balance can prove complicated when it comes to the activities associated with a central bank’s monetary policy. Indeed, the role of the European Central Bank (ECB) is above all to maintain price stability in the euro area, while acting as lender of last resort for the banking system.
How can the Eurosystem (the ECB and the national central banks) reconcile sound balance-sheet risk management with these broader societal objectives? This delicate question can be compared to the image of an acrobat balancing precariously on a tightrope. The ECB recently attempted to answer this question through adjustments to its operational framework (see Monetary plumbing | nbb.be).
Risk management for the Eurosystem’s (and the NBB’s) monetary policy operations is based on sound governance, a clear risk framework, state-of-the-art risk measurement models and detailed internal and external reporting.[1]Generally speaking, the Eurosystem’s key mission is to achieve its monetary policy objectives while incurring as little risk as possible. This mission is essential to preserve the confidence of economic agents in the Eurosystem and to allow the latter to conduct monetary policy with peace of mind under all circumstances.
[1]The financial risk management of the Eurosystem’s monetary policy operations (europa.eu), July 2015
Review of the operational framework for monetary policy
In its review of the operational framework,[2] the Eurosystem concluded that the monetary policy best suited to the specific characteristics of the euro area economy in the coming years is a demand-driven floor. This type of policy aims to distribute sufficient reserves to banks (the “floor”) while responding flexibly to their financing needs (the “demand-driven” component).
Short-term refinancing operations (i.e., operations by which banks borrow from the Eurosystem) play a decisive role in the creation and distribution of reserves, although a portion of this demand could also be met by more structural operations, such as medium- and long-term refinancing operations and securities portfolio operations. These structural operations make it possible to reduce the operational risks associated with the potential weekly renewal of banks’ substantial liquidity needs. For example, banknotes in circulation in the euro area already total 1 500 billion and will give rise to a structural liquidity shortage if not fully covered by NCB portfolios or structural monetary policy operations.
The new operational framework will be implemented gradually, in keeping with the increase in reserve requirements resulting from the redemption of securities in the monetary policy portfolios. These securities were purchased following the Governing Council’s decision to take unconventional monetary policy measures after the 2008 financial crisis and the Covid-19 pandemic in 2020.
[2]The Eurosystem’s operational framework (europa.eu), March 2024
How will this impact the size of the balance sheet?
The demand-driven creation of reserves affords banks more flexibility to meet their liquidity needs. However, monetary creation should remain moderate to avoid inflating the size of the Eurosystem’s balance sheet. Under the new operational framework, a bank that wishes to increase its reserves can do so by engaging in main refinancing operations (to which the MRO rate applies) or through the marginal lending facility (to which the MLF rate applies). If it wishes to keep the reserves so created, they will be remunerated at the deposit facility rate (DFR). The spread of 15 or 40 basis points between the MRO or MLF and the DFR should ensure that banks request only the liquidity they need, thereby limiting the size of the Eurosystem’s balance sheet and the financial risks incurred.
However, central bank demand for reserves has increased in recent years, particularly as a result of new regulatory requirements for managing banks’ financing and liquidity risks.
Refinancing operations at the heart of monetary policy: a sturdy tightrope coupled with a safety net!
Refinancing operations benefit from three risk mitigation techniques:
- Reserved access: Only financially sound banks, i.e. those subject to harmonised banking supervision at EU or EEA level, that meet solvency and liquidity regulatory requirements can participate.
- Collateral: The Eurosystem requires eligible collateral in exchange for loans. This collateral, which may take the form of marketable securities or non-marketable assets, must meet strict criteria in terms of credit quality, liquidity and complexity in order to protect the Eurosystem’s balance sheet.
- Haircuts: The Eurosystem regularly assesses the value of marketable assets and applies a haircut, depending on the type, quality and maturity of the asset. The haircut is calibrated based on a risk calculation (of the “expected shortfall” type) at a 99% confidence interval over the prospective liquidation time should the Eurosystem have to dispose of its assets as a result of default by a bank.
These three pillars are subject to monitoring and regular evaluation. Financing operations therefore constitute a very sturdy (tight)rope, with built-in protection against default. In short, there is a safety net in the event of a fall!
Strict rules for monetary policy portfolios
Purchases of monetary policy securities are also subject to a detailed framework in terms of financial and climate-related risks. In addition to eligibility criteria, regular risk monitoring is carried out, which may lead to risk mitigation measures. Moreover, the NBB shares the risks and returns on a number of portfolios with the other NCBs, thereby achieving greater diversification (see A problem shared is a problem halved: how the NBB shares risk within the Eurosystem | nbb.be).
Interest rate risk
A demand-driven system in which weekly refinancing operations act as fine-tuners has the advantage of limiting the interest rate risk incurred by the Eurosystem. This is because the main refinancing operations (MRO) rate and the deposit facility rate (DFR) are both short-term floating rates set by the ECB and move in the same direction, at the same speed.[3]
Therefore, just as a tightrope walker relies on certain safeguards to mitigate risks and damage in the event of a fall, the Eurosystem, which includes the NBB, strives to meet its societal objectives while ensuring that balance-sheet risks remain contained, thanks in particular to the new operational framework, a so-called demand-driven floor system.
[3] The same applies to the marginal lending facility (MLF) rate.
