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Central Banking 101: the EONIA heartbeat returns


Cross-posted on European Tribune

If you google EONIA heartbeat the top three hits are my own European Tribune blogs

and a Nordea research note from 16 July 2013, Liquidity draining & EUR short end which has the following to say:

EONIA heartbeat pattern has returned…

Before December 2011, EONIA tended to spike on the last day of the maintenance period, as a result of fine tuning operations conducted by the ECB. These operations were suspended in the end of 2011 and the pattern wasn’t seen any longer. Since the LTRO repayments started however, EONIA has spiked in the end of the month/quarter, and the largest spike in over a year occurred in the end of Q2 this year.

I don’t think that the ECB fine-tuning operations were suspended. What happened was indeed that the LTROs flooded the banking sector with so much excess liquidity that banks no longer needed extra liquidity at the end of ECB reserve periods in order to meet their reserve requirements. But the weekly refinancing operations which the fine-tuning operations are part of still took place.

EONIA stands for Euro OverNight Index Average, and represents the average rate at which banks lend each other money overnight. The function of this overnight lending (and related concepts such as the ECB policy rates, required reserves and maintenance periods) was explained in my first Central Banking 101 post above.

The “EONIA heartbeat” pattern was more clearly seen for a period of 10 months between August 2009 and June 2010 (click the charts to expand):


As we can see from this chart, EONIA stayed roughly constant slightly above the ECB’s deposit rate, but spiked on the last day of each ECB reserve maintenance period. The reason for this is that banks incur an opportunity cost for having cash parked as ECB reserves, so normally they keep reserves below their required amount. As the required reserves are computed as a monthly average, on the last day of the reserve maintenance period banks will borrow the funds necessary to meet the reserve requirement. The sudden demand for liquidity raises interbank lending rates, but only for the one day when this liquidity is needed.

The thing is, right after June 2010 the EONIA developed “tachycardia”:


I have marked the start of the ECB’s bond purchases (Securities Market Purchases, or SMP) on 10 May 2010 because I think it is clear that this is correlated with the start of the tachycardia. The reason is not the bond purchases themselves, which would have naturally improved the liquidity position of European banks, but the fact that the ECB “sterilised” these purchases by draining liquidity from the system in an amount equal to its SMP holdings. The ECB rate raises in mid-2011 visibly didn’t help. Personally, I believe Trichet’s governing council took these decisions (to sterilize and to raise rates) under pressure from Axel Weber and Jürgen Stark. The rate raises may perhaps be excused by the fact that inflation was trending upwards at the time and the ECB has an idiotically single-minded anti-inflation mandate. However, the sterilization was in my opinion a serious “unforced mistake”. I have argued in my previous blogs on this issue that bond purchases don’t need to be sterilised and in fact sterilization is contractionary. Here’s why.

In 2009, faced with a disintegrating interbank market, the ECB decided to switch its main refinancing operations from “fixed tender” (the ECB would decide the maximum amount of liquidity it was willing to supply, at the target interest rate) to “fixed rate, unlimited tender” (the ECB would lend freely, against eligible collateral, at the reference rate). Now, Eurozone government bonds of the kind the ECB bought in the SMP were eligible collateral for ECB refinancing operations, so after 2009 they could be turned into cash at will (at a small haircut). Now, if you have a bond that you can repo for cash at your sole option, selling it for cash to the ECB really makes little difference to your liquidity position. Therefore, banks which needed liquidity and had SMP-eligible bonds in hand were already likely to be repoing them weekly at the discount window anyway. So the liquidity injected by the ECB through the bond purchases was already in the system.

“Sterilization” means to offer banks to deposit cash with the ECB for a week, at the ECB’s reference rate. In this way, an amount of cash equal to the ECB’s SMP holdings was withdrawn from the banking system. But as we have argued, this was not extra liquidity that was injected by the SMP: the liquidity was already there. So the net effect of sterilization is to actually decrease system liquidity by the amount of its bond purchases. Therefore, the worse the sovereign debt crisis got, the more liquidity the ECB withdrew, only making matters worse. Then the ECB went and raised rates twice in the middle of a recession responding to cost-push inflation (from commodity imports) and the notional inflationary effects of VAT raises from austerity policies. A wholesale policy disaster, if you ask me.

The EONIA Tachycardia stopped at the end of 2011. This can be seen more clearly by rebasing interest rates around the ECB’s reference rate, as in the top half of the following chart:


We can see that there is a single end-of-year liquidity spike after the first 3-year LTRO, and then the EONIA heartbeat itself, let alone the tachycardia, disappeared. So, and that was the point of my second Central Banking 101 post, it was the LTRO and nothing else that got rid of the EONIA tachycardia. Even the “whatever it takes” OMT speech didn’t have a noticeable effect on the spread of EONIA over the ECB rates. The SMP sterilization continued, but now there was so much excess liquidity in the system that it didn’t matter.

Nevertheless, as can be seen more clearly in the bottom chart and was noticed by Nordea already six months ago, the EONIA heartbeat has returned. This can only be because the excess liquidity is gone, and the reason is the unwinding (prematurely, in my opinion and based on its effects on EONIA) of the LTRO. Banks have been encouraged to return the 3Y LTRO liquidity a year after it was borrowed. Part of this has been an attempt to signal to “the market” that the health of individual banks was sound, and even that the health of entire national banking systems such as Spain or Italy was good. But already in mid-2013 the EONIA hearbeat returned, and at the end of 2013 SMP sterilization failed a few times.

Failure of SMP sterilization scares de bejeesus out of inflation hawks, but as I argued at the start of 2011 when it happened a couple of times, failures of sterilization indicate that the ECB is trying to drain liquidity that simply isn’t there.

So, here we are, three years later liquidity is again so tight that sterilization is failing, and all the hawks can think of is worry that the SMP is becoming “Quantitative Easing through the back door”. With such thinking, we have a long crisis ahead of us.

  1. John Whittaker permalink

    Dear MigeruET
    Thanks for your response. I agree with everything you say except about the drainage of liquidity via the 1-week deposits. Each weekly announcement of these from the ECB (ad hoc communications) includes the words: “Fixed term deposits held with the Eurosystem are eligible as collateral for the Eurosystem’s credit operations.”
    By the way, I don’t recognise your name. Who are you?
    John Whittaker
    Lancaster University UK

    • “Fixed term deposits held with the Eurosystem are eligible as collateral for the Eurosystem’s credit operations.”

      But isn’t that money then unavailable for overnight lending among private banks?

      Also, if a bank uses a weekly deposit as collateral for borrowing reserves from the ECB, it will have to pay the marginal rate, which is a penalty of 0.50% (currently: historically it’s been 1%) over what the weekly deposit pays.

  2. John Whittaker permalink

    I have trouble with the assumption that the SMP sterilisations actually ‘drain liquidity’ from banks. The 1-week deposits are hardly less liquid than the cash deposited, particularly as they are eligible for repo with the ECB.

    Moreover, the rate paid on these deposits is a market rate determined by tender with a cap at the main refinancing rate of 0.25%. It is not surprising banks have been reluctant to deposit – the sterilisation ‘failed’ – when eonia has risen above 0.25%. Hence no information is gleaned from these failures beyond what is already in the eonia rate.

    Finally, I have a query about the eonia rate itself. It is a weighted average rate for overnight unsecured loans made by reporting banks. However, we are not told about the variation in rates among the banks or the volumes for each bank. I understand that most of the business is between ‘core’ eurozone banks rather than the periphery; if this is true, eonia reflects preferentially deals among those banks that have zero-earning cash in current accounts at the ECB or in the deposit facility. I would be very interested to see any analysis of this so-called liquidity crisis that differentiates between those banks that have reserve deposits against those that are indebted to the ECB under refinancing.

    John Whittaker
    Lancaster University, UK

    • I believe the segmentation of the Euro interbank market into “good” and “bad” banks is responsible for the EONIA being anchored around the deposit rate rather than the repo rate. In this chart one can see the change coincides with the arrival of the banking crisis to Europe and the switch from fixed-tender to unlimited-tender in the ECB’s weekly refinancing operations:

      EONIA rebased

      I don’t have data on which banks take part in EONIA lending. But if you’re a “bad bank” your cheapest funding is going to be the ECB’s repo rate while if you’re a “good bank” you’re only willing to lend to other “good banks” and you all have a relatively comfortable liquidity position, hence the low rate.

      Therefore, I think you’re right and the Eonia “liquidity crisis” reflects tight liquidity among “good banks”. The “bad banks” are still funding at the repo rate.

      On the second point: the sterilization failures are of course correlated with high EONIA. The point of mentioning the sterilization failures is that people hyperventilate when this happens about “excess liquidity” being an inflationary risk when this happens. If EONIA is spiking above repo evidently there is no excess liquidity.

      And on the first point, the sterilization deposits are weekly deposits, and EONIA is an overnight rate. When the ECB takes a deposit the cash is unavailable for overnight lending. It is in this sense that liquidity is withdrawn. Also, I don’t know how a deposit with the ECB can be eligible for a repo from the ECB. That makes no sense to me.

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