• The reduction of the ECB’s deposit rate to 0% led to an immediate Eur500 mn drop in deposit holdings but prompted a simultaneous increase in  current account holdings, leaving overall bank reserves unchanged.
• Yet, focus on these figures is misplaced: bank lending, or M3 in general, is independent of the monetary base, i.e. high reserve holdings are not indicative of “cash hoarding” by banks.
• What matters is how often these funds are passed around the financial system before they are redeposited at the ECB. As a result, the level of reserves – which further LTROs would boost – is less important than the ‘velocity’ of these funds.
• The ECB has few tools to boost ‘velocity’. Uniformly lower rates, SMP purchases, QE and, most importantly, credit easing would all help though. 

There is little doubt that the effect of Quantitative Easing (QE) – and central bank balance sheet expansion in general – can have a powerful effect on markets. The Bank of Japan’s QE operations drove the Nikkei up some 135% between 2002 and 2006, the Bank of England’s asset purchases supported a rally in the FTSE100 by 65% in its first year, while the Fed’s first round of QE pushed the S&P500 up by 77% in the year after operations began. The ECB’s December Long-Term Refinancing Operations (LTROs) did not involve asset purchases and merely provided liquidity to banks through lending (albeit at long term) and was thus not QE. But it did involve a considerable expansion of the ECB’s balance sheet and helped improve sentiment for a short period: Eurostoxx climbed 14% in the subsequent quarter while the bank subindex, the sector targeted by the operations, rose some 21%.

But reflating asset markets is only one, and arguably the least important, of a central bank’s objectives. Ultimately, the aim is to unclog the financial system and thereby reinvigorate economic activity. On this count the ECB’s measures have hardly been a success: Figure 1 shows the collapse in the Eurozone money multiplier and how little financial market activity has recovered (the marginal contribution of M3 to the money supply consists of short term debt securities, repo agreements and money market fund shares). This reflects without doubt the ongoing preference for liquidity by banks buffeted by uncertainty in market conditions, the economic outlook and the regulatory environment. In an attempt to disincentivise banks to hoard funds in its own accounts, the ECB thus decided in July to lower the remuneration on such deposits and reduced the rate to 0%. This move reduced holdings in the deposit facility by about Eur500 mn but led to an immediate and commensurate increase in bank current accounts as shown in Figure 2.

The Missing Link: Base Money and M3

It is important to note though that the amount of reserves held at the ECB (whether in its deposit facility or in current accounts) is not indicative of the amount of lending, or the lack thereof, the system undertakes. Once a central bank decides to create excess reserves, the level of these reserves will not change, irrespective of the amount of lending private banks undertake. Raising lending any number of times cannot change the amount of reserves held at the central bank in a closed monetary system. This simply reflects the fact that every time a loan is made, the bank creates an asset for itself and a liability for the borrower which is used to purchase goods or services, the proceeds of which the seller of those goods or services redeposits at a bank. This process may involve a number of additional intermediaries but ultimately, the last bank will place its deposits at the central bank, leaving the aggregate amount of base money (notes and coins in circulation plus bank reserves) unchanged. This then allows broad money to rise even as the monetary base remains the same, which is essentially the process that took place during much of the past decade.

Only by trading with the central bank itself can commercial banks reduce their reserves. This requires the withdrawal of reserves in physical banknotes. The monetary base would still remain unchanged but any drop in bank reserves would be matched by a commensurate increase in cash (a move that would be of concern for inflation fighters). But importantly, it is the central bank that controls the monetary base and the private sector that determines broad money.

Reducing the amount of excess reserves is not up to commercial banks either but requires the central bank to deflate its balance sheet. It can do this through various means, including asset sales, reverse repos or indeed negative interest rates. This is why imposing negative interest rates on reserves as advocated by some would be counterproductive: such a move would invariably shrink the monetary base as banks would have to use the reserves just injected into the system to pay the interest rate charged on them. It is thus surely not an action that would spur on lending.

In sum, there is no strict mechanical link between base money and M3. The two can move together, but at different speeds as in much of the past decade, or they can move in opposite directions as in this crisis period. In particular, reserve holdings at the central bank are in no way demonstrative of the extent of “cash hoarding”: this simply depends on how many times the parcel has been passed around the system – how much credit was extended, how many bond redemptions met, how many government securities bought etc before the last bank deposits the fund at the ECB at the end of the day. Information on these activities can only be gleaned from other indicators that capture them more directly (e.g. bond spreads, credit surveys, bond redemptions and refinancing etc).

Next Steps: Boost Velocity

This is not so say that an expansion of the monetary base as the ECB achieved through its LTRO is a complete waste. The notion that the parcel was indeed being passed around the system at least to some extent was supported by President Draghi’s comments that the banks borrowing from the ECB under the LTRO were different from those depositing funds. Most likely, it was the weak peripheral banks doing the borrowing and the stronger creditor banks doing the depositing. The (temporary) drop in sovereign spreads adds further support to the view that these funds were being deployed.

Ultimately though, boosting the supply of funds and reducing their cost merely creates the ‘enabling environment’ for banks to operate. It remains up to the private sector banks to assess the risks and opportunities they face and act accordingly. The extension of credit and the engagement in other risky financial activity depends on factors beyond the central bank’s control. As a result, there is not a lot the central bank can do to ignite bank lending.

Within its limited abilities, it will be key for the ECB to maintain easy funding conditions. It can go further out the curve providing liquidity and steering market rates down. Some banks will face difficulties in their ability to post sufficient and adequate collateral. The ECB can support them in further easing its collateral framework. More importantly, the most potent tool could be a program of credit easing, whereby the ECB purchases bad assets from banks. Traditional quantitative easing, renewed SMP operations and taking credit losses on sovereign debt are further actions that could ease strains on the banking system and sovereigns alike. In general, any expansion of the ECB’s balance sheet is likely to further weaken the euro, which in turn would help alleviate some of the external strains of peripheral countries (though without affecting intra-EZ imbalances).

In general, the ECB will aim to focus on measures that boost the ‘velocity’ with which its funds slush around the system rather than simply raise their level further.