The reserve fulfilment path of euro area commercial banks: empirical testing using panel data

The theory of liquidity management under uncertainty predicts that, under certain conditions, commercial banks will accumulate minimum reserve requirements linearly over the reserve maintenance period. This prediction is empirically tested using daily data (from March 2004 until February 2007) on the current accounts and minimum reserve requirements of a panel of 79 commercial banks from the euro area. The linear accumulation hypothesis is not rejected by the data with the exception of small banks which build-up excess reserves. The empirical analysis suggest that idiosyncratic liquidity uncertainty is much higher than aggregate liquidity uncertainty. Nevertheless, on the penultimate day in the reserve maintenance period, the inverse demand schedule of the representative bank is relatively flat around the middle of the interest rate corridor set by the standing facilities. This suggests that liquidity e¤ects on the overnight inter-bank rate should be very muted on this day. Our calibration exercise suggests that the probability of an individual bank's daily overdraft in the euro area is very low (less than 1:0%). This is conrmed by the analysis of the daily recourses to the marginal lending facility by the panel banks. JEL Classification: C23, E4, E5, G2liquidity management, monetary policy implementation, Panel data, Rate corridor, reserve requirements

The Euro overnight interbank market and ECB's liquidity management policy during tranquil and turbulent times

We analyze the impact of the recent financial market crisis on the Euro Overnight Index Average (EONIA) and interbank market trading and assess the effectiveness of the ECB liquidity policy between 07/2007 - 08/2008. We extend the model of [QM06] by (i) incorporating the microstructure of the EONIA market including the ECB fine-tuning operation on the last day of the maintenance period (MP) and banks’ daily excess liquidity, (ii) giving insight into banks’ trading behavior characterized by an endogenous regime-switch and suggesting an efficient procedure to simulate the entire MP, and (iii) proposing a model for market distortion due to lending constraints which lead to a bid-ask spread for the EONIA rate. The model is calibrated by simulation fitting daily EONIA rates and aggregate liquidity measures observed between March 2004 and September 2008. Besides lending constraints we consider market segmentation and aggregate liquidity shocks as possible market distortions in the crisis period. For a calibration cross-check and for estimating the timing of the endogenous regime-switch we use panel data covering liquidity data of 82 Euro Area commercial banks for the period 03/2003 - 07/2007. With the calibrated model the ECB policy of liquidity frontloading is evaluated and compared with a reserve band system policy similar to the Bank of England’s framework. We find that liquidity frontloading is a small scale central bank intervention which is capable of stabilizing interest rates in both frictionless and distorted markets. Simulations suggest that without frontloading the EONIA would have been, on average, 23 basis points above the policy rate (target); with frontloading, the overnight rate is, on average, on target. JEL Classification: E44, E52, G21liquidity management, Microstructure, Open market operations, Simulation

Modelling short-term interest rate spreads in the euro money market

In the framework of a new money market econometric model, we assess the degree of precision achieved by the European Central Bank ECB) in meeting its operational target for the short-term interest rate and the impact of the U.S. sub-prime credit crisis on the euro money market during the second half of 2007. This is done in two steps. Firstly, the long-term behaviour of interest rates with one-week maturity is investigated by testing for co-breaking and for homogeneity of spreads against the minimum bid rate (MBR, the key policy rate). These tests capture the idea that successful steering of very short-term interest rates is inconsistent with the existence of more than one common trend driving the one-week interest rates and/or with nonstationarity of the spreads among interest rates of the same maturity (or measured against the MBR). Secondly, the impact of several shocks to the spreads (e.g. interest rate expectations, volumes of open market operations, interest rate volatility, policy interventions, and credit risk) is assessed by jointly modelling their behaviour. We show that, after August 2007, euro area commercial banks started paying a premium to participate in the ECB liquidity auctions. This puzzling phenomenon can be understood by the interplay between, on the one hand, adverse selection in the interbank market and, on the other hand, the broad range of collateral accepted by the ECB. We also show that after August 2007, the ECB steered the “risk-free” rate close to the policy rate, but has not fully off-set the impact of the credit events on other money market rates. JEL Classification: C32, E43, E50, E58, G15co-breaking, Credit risk, euro area, fractional co-integration, fractionally integrated factor vector autoregressive model, liquidity risk, long memory, money market interest rates, Structural change, sub-prime credit crisis

Monetary policy and the stock market in the euro area

In this paper we study the role of the stock market in the transmission mechanism in the euro area and evaluate whether price stability and financial stability are mutually consistent and complementary objectives. Four major conclusions can be drawn from our work. First, stock prices and more generally, relative asset prices seem to play an important role in the transmission mechanism in the euro area. Second, we do not find any significant, direct impact of stock prices on inflation. These two findings taken together support the view that stock market prices may be important for monetary policy, independently of their direct impact on inflation. Third, permanent productivity shocks are the driving force of the stock market in the long-run and contribute significantly to its cyclical behaviour. Nevertheless, the bulk of cyclical dynamics in the stock market is explained by transitory shocks. Fourth, a monetary policy focused on maintaining price stability in the long-run can contribute also to stock market stability. JEL Classification: C32, O11financial stability, Monetary policy transmission mechanism, price stability

Emu, Exchange Rate Volatility and Bid-Ask Spreads

This study deals with two issues related to the determination of exchange rate bid-ask spreads in the transition to EMU. First, we discuss how a credible announcement of conversion rates affects exchange rate volatility in the run up to the introduction of the Euro. Second, we discuss the theoretical relation that exists between exchange rate uncertainty and the bid-ask spread. The theory suggests that there is a positive association between exchange rate uncertainty and transaction costs and that we should observe a gradual reduction of exchange rate volatility in the transition to EMU. This theory implies a gradual shrinking of the bid-ask spread during the transition period. These conjectures are subject to empirical testing in the case of the exchange rate of the Portuguese escudo against the Deutsche Mark.

Comovements in volatility in the euro money market

This paper assesses the sources of volatility persistence in Euro Area money market interest rates and the existence of linkages relating volatility dynamics. The main findings of the study are as follows. Firstly, there is evidence of stationary long memory, of similar degree, in all series. Secondly, there is evidence of fractional cointegration relationships relating all series, except the overnight rate. Two common long memory factors are found to drive the temporal evolution of the volatility processes. The first factor shows how persistent volatility shocks are trasmitted along the term structure, while the second factor points to excess persistent volatility at the longer end of the yield curve, relative to the shortest end. Finally, impulse response analysis and forecast error variance decomposition point to forward transmission of shocks only, involving the closest maturities. JEL Classification: C32, F30, G10fractional integration and cointegration, fractional vector error correction model, liquidity e¤ect, money market interest rates, realized volatility

A two-factor model of the German term structure of interest rates

In this paper we show that a two-factor constant volatility model provides an adequate description of the dynamics and shape of the German term structure of interest rates from 1972 up to 1998. The model also provides reasonable estimates of the volatility and term premium curves. Following the conjecture that the two factors driving the German term structure of interest rates represent the H[-DQWH real interest rate and the expected inflation rate, the identification of one factor with expected inflation is discussed. Our estimates are obtained using a Kalman filter and a maximum likelihood procedure including in the measurement equation both the yields and their volatilities JEL Classification: E43, G12affine model, expectations hypothesis, pricing kernels, term premiums

The 2007-? financial crisis: a euro area money market perspective

Motivated by the “shocking” evidence of non-stationary behavior of money market spreads during the crisis, we investigate the economic and statistical features of money market turbulence by means of a Fractionally Integrated Heteroskedastic Factor Vector Autoregressive model. This approach allows for an accurate modelling of the persistence properties of the data, and to decompose the EURIBOR-OIS spreads into three components bearing an economic interpretation. We find that the increasing trend in the spreads after August 2007 was broken and reversed in December 2008. This coincides with the timing of a large ECB policy rate cut which, together with other policy measures, paved the way for a gradual reversal in market sentiment, and reduction in credit and liquidity risks. Key words: money market interest rates, credit/liquidity risk, fractionally integrated heteroskedastic factor vector autoregressive model.

The 2007 Subprime Market Crisis Through the Lens of European Central Bank Auctions for Short-Term Funds

In this paper we study European banks’ demand for short-term funds during the 2007 subprime market crisis. We use bidding data from the European Central Bank’s auctions for one-week loans. Through a model of bidding, we show that bank behavior reflects the cost of obtaining short-term funds elsewhere as well as a strategic response to other bidders. We find considerable heterogeneity across banks in their willingness to pay for short-term funds supplied in these auctions. Accounting for the strategic component is important: while a naive interpretation of the raw bidding data may suggest that virtually all banks suffered a dramatic increase in the cost of obtaining funds in the interbank market, we find that for about one third of the banks, the change in bidding behavior was simply a strategic response. Using a complementary dataset, we also find that bank pre-turmoil liquidity costs, as estimated by our model, are predictive of their post-turmoil liquidity costs, and that there is considerable heterogeneity in these costs with respect to the country-of-origin. Finally, among the publicly traded banks, the willingness to pay for short-term funds in the second half of 2007 are predictive of stock prices in late 2008.multiunit auctions, primary market, structural estimation, subprime market, liquidity crisis

Structural Econometric Approach to Bidding in the Main refinancing Operations of the Eurosystem

This paper contributes to the existing literature on central bank repo auctions. It is based on a structural econometric approach, whereby the primitives of bidding behavior (individual bid schedules and bid-shading components) are directly estimated. With the estimated parameters we calibrate a theoretical model in order to illustrate some comparative static results. This exercise sheds light on the debate about the reversed winner's curse found in the empirical literature on ECB auctions by showing that it may be related to an identification problem. Overall the results suggest that strategic and optimal behavior is prevalent in ECB tenders. We find evidence of a statistically significant bid-shading component, even though the number of bidders is very large. Bid-shading increases with liquidity uncertainty and decreases with the number of participants and with price uncertainty. We argue that a sufficient condition for the latter effect to appear in the data is that the residual supply facing an individual bidder does not change much ex-post when very short-term market rates increase.repo auctions, monetary policy implementation, primary money market market, multi unit auctions, discriminatory auctions, collateral, central bank, nonparametric estimation