Seminar in Finance, University of Konstanz 2012

1. Seminar : Financial Risk of Bank and Sovereign
Topic : Reallocation of Risks Through the Central Bank System in the ECU
Prof.Dr.Dr.h.c. Student :
Günter Franke Marco Matrisciano
Gian Marco Melandri 1

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‐ Introduction and executive summary ‐
The financial crisis and the ensuing recession have caused a sharp deterioration in public finances especially in the euro area, where some countries have seen their credit ratings downgraded during 2009‐11 and their funding cost rise sharply. The crisis ha underlined the strong interdependence between the euro‐area banking and the sovereign risk. This working paper sheds light on this link. Our analyses start from a short summery of Euro System of Central Banks, the Eurosystem and ECB’s objective, and lather on, go into deep analysis of the instruments and the programme used by the euro authorities for the monetary policy operation. At first we focus on the Target2, a centralized system able to regulate the member states’ imbalances of the balance of payments in the European Union, with some data of the last few years. Afterwards it goes on with a description of the Longer‐Term Refinancing Operations with some data of the last few years and a short explanation of the Security market programme, a non‐standard measure adopted by the euro‐system to fight the sovereign debt crisis caused by the Greek debt crisis.
In the second part of the topic, we describe the risk management instrument used by Eurosystem in the liquidity management to mitigate the effects of credit risk, liquidity risk, market risk and exposure rate risk. This analysis start from the main transmission channels of these risk, the open market operations, that play an important role in the monetary policy of the ECB for the purpose of steering interest rate and managing the liquidity situation in the market. As a consequence we shift to the first measure taken by ECB to mitigate the possible losses, or rather how the Eurosystem chose their counterparties in the open market operation and how the guarantee used can be eligible as collateral.
To support the second part of the topic we used a collection of 2011 data taken from ECB annual report, and unfortunately we could not use the data of 2012 because they are not yet complete. The last part of the topic is focused on sovereign exposure of the bank and in particular how the risks are shift from the bank to the central banks, concluding with the possible political implications of this phenomenon.

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1 ‐ European Central Bank's objectives
Article 282 of the consolidated version of the Treaty on the Functioning of the European Union:
“1. The European Central Bank, together with the national central banks, shall constitute the European System of Central Banks (ESCB). The European Central Bank, together with the national central banks of the Member States whose currency is the euro, which constitute the Euro‐system, shall conduct the monetary policy of the Union.
2. The ESCB shall be governed by the decision‐making bodies of the European Central Bank. The primary objective of the ESCB shall be to maintain price stability. Without prejudice to that objective, it shall support the general economic policies in the Union in order to contribute to the achievement of the latter’s objectives.”
As the article explains, the European System of Central Banks (ESCB) is comprised of the ECB and the national central banks (NCBs) of all EU Member States, regardless of whether they have adopted the euro. The ESCB has no legal personality, but the NCBs and the ECB do. The European Central Bank and the national central banks of the 17 Member States whose common currency is the euro have given life to the Euro‐system. It carries out the central bank functions for the euro area and conducts the monetary policy of the Union. The Euro‐system is thus a sub‐set of the ESCB and is the central banking system of the euro area. To fulfil its primary objective the Euro‐system uses this set of monetary policy instruments and procedures:
1. open market operations,
2. standing facilities,
3. minimum reserve requirements for credit institutions.1
The main objective and the tasks of the European System of Central Banks are explained in the Article 127 (ex Article 105 TEC) of the consolidated version of the Treaty on the Functioning of the European Union:
“1. The primary objective of the European System of Central Banks (hereinafter referred to as ‘the ESCB’) shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European
1 http://www.ecb.int/mopo/implement/intro/html/index.en.html

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Union. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 119.
2. The basic tasks to be carried out through the ESCB shall be:
— to define and implement the monetary policy of the Union,
— to conduct foreign‐exchange operations consistent with the provisions of Article 219,
— to hold and manage the official foreign reserves of the Member States,
— to promote the smooth operation of payment systems.”
The European Central Bank (ECB) is a supra‐national institution with its own legal personality. It is also the central bank for Europe's single currency, the euro, and it takes over the decision‐making powers in monetary matters of national central banks (NCBs). Moreover, it has gained the power to yield the monetary policies of the member states. Member states have also lost the power to print money, this is the prerogative of sovereign states. The European Central Bank has as its primary objective to maintain price stability and to preserve the purchasing power of the single currency. It is important that the European Central Bank keeps total independence from political power. The price stability is defined by the ECB’s Governing Council through a year‐on‐year increase in the Harmonised Index of Consumer Prices (HICP), and in particular the level for the euro area must be below 2%. The objective of price stability refers to the general level of prices in the economy. It implies avoiding both prolonged inflation and deflation. Price stability also contributes to achieving high levels of economic activity and employment. The ECB may be considered the central element of European monetary union.
“The main tasks of the ECB are:
1. Defining Eurosystem policies
2. Deciding, coordinating and monitoring the monetary policy operations
3. Adopting legal acts
4. Authorising the issuance of banknotes
5. Interventions on the foreign exchange markets
6. The operation of payment systems and the oversight of payment and other financial market infrastructures
7. International and European cooperation
8. Statutory reports
9. Monitoring financial risks

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10. Fulfilling advisory functions for Union institutions and national authorities
11. Running the IT systems
12. Strategic and tactical management of the ECB's foreign reserves”. 2
The European Central Bank is committed to effectively performing all central banking functions bestowed upon it. In doing so, it pursues the highest level of integrity, competence, efficiency and transparency.
The national central banks of the Euro‐system have a legal personality distinct from that of the European Central Bank and they perform almost all operational tasks of the Euro‐system, by implementing the decisions taken by the Governing Council of the ECB.
“Tasks of the national central banks (NCBs) are:
1. Execution of monetary policy operations
2. Operational management of the ECB's foreign reserves
3. Management of their own foreign reserves
4. Operation and oversight of financial market infrastructures and payment instruments
5. Joint issuance of banknotes together with the ECB
6. Collection of statistics and providing assistance to the ECB
7. Functions outside the European System of Central Banks (ESCB)”3
The ECB and the NCBs work together to achieve the common objectives of the Euro‐system.
2 http://www.ecb.int/ecb/educational/facts/orga/html/or_012.it.html
3 http://www.ecb.int/ecb/educational/facts/orga/html/or_014.it.html

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1.2 ‐ Target2
One of the primary objectives of the Euro‐system is to implement a more cohesive integration of the financial and economic infrastructure within the community. When the Euro was introduced, the Committee of European central banks (the Euro‐system) launched a project called Target1 (acronym for Trans‐European Automated Real‐time Gross Settlement Express Transfer System) in order to regulate activities and interbank payments. Target1 is composed of the gross settlement systems of the 17 EU Member States and the European Central Bank. The ability of Target1 to execute interbank payments in the euro area in a safe, reliable and efficient manner has made possible the effective conduct of monetary policy with the euro. At the same time it has given significant impetus to the process of financial integration and trade between participating countries. The advent of the single currency has refined and better integrated the processes of regulation agreed upon in 1999. For this purpose Target2, a centralized system able to regulate and then balance in real time the imbalances of the balance of payments of member countries of the European Union, has been created. The central bank payment systems are typically used for settling claims from interbank operations and auxiliary systems. These auxiliary systems regulate a variety of activities including retail payment, clearing houses, securities transactions and foreign currency. In October 2002, the Target2 project was launched with a goal to optimize the Target system, both for a general improvement of the system, and to facilitate the entry of the future members of the Euro‐system. On 19 November 2007 the Target2 system was initiated and replaced the previous Target system. It uses a Single Shared Platform (SSP) created and managed by the Bank of Italy, the Deutsche Bundesbank and the Banque de France for the benefit of European financial systems, which operationally and legally refer to the respective central banks on the basis of harmonized rules. Target2 became operational with the first group of countries (Austria, Cyprus, Germany, Latvia, Lithuania, Luxembourg, Malta and Slovenia) to test its function properly. The gradual transition from Target1 to Target2, started in November of 2007, and was completed in an orderly manner and in compliance with the deadline of May 19, 2008 which would connect the third and final group of national banks (Denmark, Estonia, Greece, Italy, Poland and the ECB) to Target2. The new system responds to the question of the banks harmonized and developed services, especially for liquidity management, the demands posed by the European

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Union and the Euro‐system in search of higher levels of efficiency and finally to the new demands in terms of business continuity. This is done by adopting advanced technological solutions. Target2 is used for the settlement of central bank operations and interbank transfers and other large‐value payments in euro currency. It allows real‐time processing, settlement in central bank money and immediate finality of the Regulation. However, different from the old system Target1, in which all payments were processed by the NCBs on a decentralized basis, Target2 operates through a Single Shared Platform (SSP) without the intervention of central banks. The platform makes possible to offer a harmonized service, and also allows economies of scale and lower rates to be applied. This achieves greater efficiency in terms of cost. Target2 is the second generation of Target1 and is one of the largest payment system in the world. Target2 has to be used for all payments involving the Euro‐system and it is accessible to a large member of participants of the 23 European countries that it connects. The Target2 system had 976 direct participants, 3,465 indirect participants and 13,083 correspondents. Payment transactions are settled one by one on a continuous basis in central bank money with immediate finality. There is no upper or lower limit on the value of payments and the average value of a Target2 transaction is €6,8 million. With the use of Target2 for all large‐value payments, especially those related to interbank transactions, market participants receive excellent service and contribute greatly to reduce systemic risk across the EU. To be more precise, the risk of "contagion "to other areas resulting from the large number and high value interactions between banks is lowered. The Target2 was originally conceived as a mere instrument for the regulation of accounting items and payments, however, after the outbreak of the subprime mortgage crisis in 2008 and sovereign debt in 2010, Target2 was also used to keep solvent the Euro‐system, in particular, the bank apparatuses of the nations most ailing. Central banks, in fact, have significantly increased their credits to credit institutions in their countries. To finance these loans, the central banks of GIIPS (Greece, Ireland, Italy, Portugal and Spain) have found liquidity from other central European institutions, in particular the Bundesbank. For this purpose the Bundesbank has gradually reduced funding for financial institutions and at the same time Germany has transferred more money to central banks of the Euro‐system.
When an institution makes a payment to a bank in another country through the payment system Target2 , the transaction is settled in central bank money, influencing the current account balances of banks with their respective central banks. Before the financial crisis and sovereign debt crisis, credits and debits of NCBs in Target2 were relatively stable. This is because the flow of cross‐border payments in euro area countries tended to be broadly balanced. With the crisis,

8. liabilities for some NCBs in Target2 have increased, because their banking systems recorded payments outflows in euro not matched by the payment inflows with the euro. The Chart 1 shows a comparison between the data of NCBs in the end of 2007, 2010, 2011.
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Chart 1 – Target2 balances of euro area NCBs
Finally some data and some comparisons on payment traffic inTarget2 of the last few years:
In 2010 the Target2 system has operated regularly, treating a large number of payments in euro. In value terms, in 2010 the traffic of payments amounted to €593.194 billion, with a daily average of €2.299 billion. Compared to the previous year (2009), the total value of transactions settled by the system increased by 7.6 percent.
The table 1 presents a summary of payments passed in Target2 during the 2010 and a comparison with the previous year (2009). Participants have expressed satisfaction with the excellent performance of the system, constantly improving since the migration to Target2.
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4 Annual Report BCE 2011 Page: 36

9. The tab 1 and tab 2 present a summary of payments passed in Target2 during the 2010 and a comparison with the 2009 and the 2011 in terms of value and volume of transactions in the system Target2. In the 2010 participants have expressed satisfaction with the excellent performance of the system, constantly improving since the migration to Target2. As can be seen even in 2011 there was slight increase in the volume of payments and also in the number of transactions.
Tab 1 ‐ Payment traffic in TARGET2
Tab 2 –Payment traffic in TARGET2 56
1.3 ‐ LTRO (Longer‐Term Refinancing Operations)
The Longer-Term Refinancing Operations are regular open market operations executed by the euro- system in the form of temporary operation. The other open market operation are the Main Refinancing Operations MROs and the fine-tuning operations . All financial institutions authorized by Monetary Union can take part (if they respect European collateral) , in order to regulate the situation of liquidity in the euro area. These operations, carried out through monthly standard auctions are characterized by the monthly frequency and longer term, equal to more than a month and usually equal to three months. Another feature of these operations is that they are usually issued at variable rates, which means that the European Central Bank shall determine only the amount that can enter into the system, previously announced, while the rate at which it is placed will depend on
5 Annual Report ECB 2010 page: 104 9
6 Annual Report ECB 2011 page: 90

10. the demand of the banks. Through Longer-Term Refinancing Operations, the Central Bank does not report information about the orientation of monetary policy because the interest rate is not executed under its direct control but depends on market response. Consequently, it acts normally in order not to influence the interest rate. For this purpose, Longer-Term Refinancing Operations quotations are usually made through variable rate auctions. Periodically, the ECB indicates the level of funding that will be allotted in forthcoming auctions. In exceptional circumstances, the ESCB may also do Longer-Term Refinancing Operations with fixed-rate auctions. With Longer-Term Refinancing Operations, rather, the Central Bank provides additional liquidity to the banking system of European monetary union, complementary to that provided by the main refinancing operations.
The chart 2 shows the development and the volume of the main and longer-term refinancing operations from January 1999 to June 2003. The liquidity was mainly provided through the Main Refinancing Operations and in addition provided through the Longer-Term Refinancing Operations. As can be seen from the figure, the amount of Longer-Term Refinancing Operations is between €45 billion and €75 during the period under consideration.
Chart 2 – Volume of the main and longer‐term refinancing operations7
At the beginning the amount of Longer‐Term Refinancing Operations was only €15 billion, but over the time the amount has gone from €15 to €20 billion and from €20 to €25 billion in January of 10
7 European Monetary policy – 2004, Page: 89

11. 2004 and from €25 to €30 billion in January 2005. Subsequently the allotment volume in each operation was increased from €30 billion to €40 billion in January 2006 and to €50 billion in January 2007. Over time additional operations were introduced: supplementary Longer‐Term Refinancing Operations with three month and six‐month maturities, and special term refinancing operations, with a maturity equal to the length of the maintenance period. In 2008 there were the first new Longer‐Term Refinancing Operations with six‐months maturities. On the 7 May 2009 The Governing Council of the ECB decided to conduct liquidity‐providing longer‐term refinancing operations with a maturity of one year. These operations were conducted in addition to the regular and supplementary Longer‐Term Refinancing Operations. In the Tab 3 there is the 2009 year calendar for the longer‐term refinancing operations with a maturity of one year.
Tab 3 – Longer‐term refinancing operations with a maturity of one yearof 2009 8
The gradual phasing‐out of non‐standard measures at the beginning of 2010 led to the discontinuation of supplementary Longer‐Term Refinancing Operations with three‐month and six‐ month maturities. However, special‐term refinancing operations, introduced in September 2008, the maturity of which is synchronised with the respective maintenance period, were kept.
As can be seen from the chart 3 in the first half of the 2010, before the first one‐year Longer‐Term Refinancing Operations matured, the daily average outstanding volume of liquidity allotted in the Longer‐Term Refinancing Operations, supplementary Longer‐Term Refinancing Operations and special‐term refinancing operations was €671 billion. In the second half of the year the daily average fell to €431 billion before the maturing of the second one‐year Longer‐Term Refinancing Operations on 30 September, and then decreased further to €333 billion during the last quarter of the year.
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8 Annual Report ECB 2009 Page: 248

12. Chart 3 – Outstanding volume of monetary policy operations9
Finally, on 22 December 2011 was a three‐year supplementary Longer‐Term Refinancing Operations for a total amount of €489.2 billion, in witch 523 counterparties participated.
The figure below shows the trend and the different volume of monetary policy operations in 2011. As can be seen from chart 4, the one‐years Longer‐Term Refinancing Operations started in October 2011 disappears. This because that operations of €45.7 was included in the three‐year supplementary Longer‐Term Refinancing Operations of the 22 December 2011.
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9 Annual Report ECB 2010 Page: 95

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Chart 4 – Outstanding volume of monetary policy operations
1.4 ‐ SMP (Securities Market Programme)
The main cause of the creation of the Securities Market Programme was the Greek debt crisis, that in the subsequent short time created the sovereign debt crisis in the rest of the continent. The increase of Greek yield bonds began in 2008 with the bankruptcy of Lehman Brothers. In all the European capitals this event pushed yields upwards and also caused a decoupling of the Greek yields from the European yields. Finally, the situation continued to worsen, and peaked in 2010 when Greece was unable to find the resources necessary to pay an extensive amount of its debt and was also unable to access credit in the financial markets. After a while, when Ireland and Portugal yields also started to grow up, the problem was no longer confined only to Greece, and the contagion became a real fear.
In the chart 5 can be seen that in the 2008 the Greece bond spread start to increase and in the 2010 it will increase more and more, immediately followed by Ireland and Portugal.
10 Annual Report ECB 2011 Page: 82
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Chart 5 – A ten‐year sovereign bond spreads
The chart 6 denotes that the spreads for the ten‐year government bonds of some euro area countries relative to German government bonds started to increase very quickly. The widening of spreads accelerated in April and early May 2010, and arrived to levels never seen before.
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Chart 6 – Government bond spread in 2010 and early 2011
On the 14 May 2010 the Governing Council of the European central bank, having regard for the Treaty on the Functioning of the European Union, to the Statute of the European System of Central Banks and of the European Central Bank, started the securities market program. This
11 http://placeduluxembourg.wordpress.com/2012/03/02/ecb‐market‐intervention‐the‐securities‐market‐programme‐smp/
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12 Annual Report ECB 2010 Page: 18

15. program is one of the two non‐standard measures adopted by the euro‐system (the second one is the covered bond purchase program). The program will be temporary because of the current exceptional circumstances in financial markets that are characterised by severe tensions in certain market segments which are hampering the monetary policy transmission mechanism. The effective conduct of monetary policy oriented to the price stability in the medium term, the main objectives are to address the malfunctioning of securities markets, restore an appropriate monetary policy transmission mechanism and also the effective conduct of monetary policy oriented towards price stability in the medium term. In practice, the program is implemented by the euro‐system portfolio managers carrying out purchases of certain euro area debt securities in market interventions. The titles of the sovereign debts are financial contracts that are auctioned off by the government of sovereign state to finance their budgets deficit. With these contracts the government of sovereign states can acquire debts from the financial market. To limit the inflationary effects of this, the European Central Bank organizes the auction of fixed term deposits. The next graphic shows the periods of purchasing during the securities market program since the beginning on May 2010 until February 2012. As we can see from chart 7 the two biggest period of purchasing were the first of May to July 2010, and the second period from August 2011 to January 2012. Between these two periods, we can note also that there were four months without intervention from April to July 2011.
Chart 7 – SMP purchases and total
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On the 31 December 2010 the euro‐system had purchased securities under the Securities Market Program with a total settlement amount of around €73.5 billion, and then, to reabsorb the liquidity of the Securities Markets Program, the ECB conducted liquidity‐absorbing fine‐tuning operations to collect one‐week fixed‐term deposits for a weekly amount corresponding to the settled size of the Securities Market Programme itself. Under the Securities Market Programme, in 2011, a total amount securities of €144.6 billion was purchased, most of which was realized from 7 August 2011 to the end of the 2011. On 30 December 2011, the euro‐system had purchased securities in SMP for Regulation of a volume of approximately €211.4 billion.
2 ‐ Risk Management instruments in ECB monetary policy operation
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13 http://placeduluxembourg.wordpress.com/2012/03/02/ecb‐market‐intervention‐the‐securities‐market‐programme‐smp/

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The primary objective of the Eurosystem is to maintain price stability, as defined in Article 127 of the Treaty. Without prejudice to the primary objective of price stability, the Eurosystem has to support the general economic policies in the Union. In the pursuing its objectives, is exposed to many types of risk, especially in the liquidity management, where the most important are credit risk, market risk, liquidity risk and exposure rate risk. Analyze them in detail.
The credit risk is an investitor’s risk of loss arising from a borrower who does not make payment as promised, but for the ECB its quite subtle due to the high number of counterparty and the size of the contracts traded. To mitigate the credit risk, the ECB is focused at first on the choice of counterparties, that must fulfill certain eligibility criteria defined with a view to giving a broad range of institutions access to Eurosystem monetary policy operations. This enhances equal treatment of institutions across the euro area and ensuring that counterparties fulfill certain operational and prudential requirements. Are eligible as counterparties only the institutions that, are subject to the Eurosystem’s minimum reserve system, are financially sound and fulfill any operational criteria specified in the relevant contractual or regulatory arrangements applied by the respective NCB, so as to ensure the efficient conduct of Eurosystem monetary policy operations. Only the counterparties that respect this criteria can have access to the Eurosystem’s standing facilities and participate to Open Market Operation that are based on standard tenders. The most important market operation where the Eurosystem its exposed to credit risk and liquidity risk are the Open Market Operation. This operation play an important role in the monetary policy of the ECB for the purpose of steering interest rate and managing the liquidity situation in the market. There are five type of instrument that the ECB can use, the most important is the reverse transaction, based on repurchase agreement or collateralized loans, the outright transaction, the issuance of ECB debt certificates, the foreign exchange swaps and the collection of fixed‐term deposit. This operation can be execute on the basis of standard tenders, quick tenders or bilateral tenders, and can be divided in four categories:
• The Main refinancing operations are regular liquidity‐providing reverse transactions with a weekly frequency and maturity of normally 1 week, are executed by the NBCs on the basis of standard tenders
• The long‐term refinancing operation ( LTRO ) are liquidity‐providing reverse transaction with a monthly frequency and a maturity of normally 3 month. The aim of this operations is providing additional longer‐term refinancing to the counterparties on the basis of standard tenders.

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• Fine‐tuning operations are execute on an ad‐hoc basis with the aim of managing the liquidity situation in the market and steering interest rate. The goal of this kind of operation is smooth the effects on the interest rate caused by unexpected liquidity fluctuations in the market. Normally are execute as reverse transactions, but may also take the form of either foreign exchange swaps or collection of fixed‐term deposit.
• Structural reverse operations in the form of reverse open market transactions aimed at adjusting the structural position of the Eurosystem in the financial sector. These are liquidity‐providing operations and their frequency can be regular or non‐regular with a maturity that is not standardized a priori.
Another important operation where the ECB is exposed to the credit risk and liquidity risk is the standing facilities, or rather the marginal lending facility and the deposit facility. The first one is a type of instrument which the counterparties can use to obtain overnight liquidity from NCBs at pre‐specified interest rate against eligible assets, in this way they can satisfy temporary liquidity demand. The interest rate on this facility operations provides a ceiling for the overnight market interest rate. The NCBs may provide liquidity under the marginal lending facility through overnight repurchase agreement or as overnight collateralized loans. The only days when is possible obtain this financing are when Target2 system is operational, and the maturity of credit extended under the facility is overnight, and the interest rate is announced in advance by the Eurosystem and is calculated as a simple interest rate based on the day‐count convention ‘actual/360’. For the counterparties that participating directly in Target2 the credit is repaired on the next day on which Target2 and SSSs are operational. The other one operation is the deposit facility that the counterparties use to make overnight deposit with the NCBs remunerated at a pre‐specific interest rate. This rate on facility provides a floor for the overnight market interest rate, and the peculiarity is that no collateral is given to the counterparties for the deposit. The access conditions for the individual who want to use this operation are the same of the marginal lending facility, in particular in relations of Target2 system access. Concerning to exchange rate risk, the main operation where the ECB try to mitigate this risk is the Foreign exchange Swaps. This type of instrument executed for monetary policy purpose consist of simultaneous spot and forward transactions in euro against a foreign currency. They are used for fine‐tuning purpose with the aim of managing the liquidity situation in the market and steering interest rate, and their frequency and maturity are not standardized. With this instrument the Eurosystem buys (or sell) euro spot

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against a foreign currency and, at the same time, sell (or buys) it back in a forward transaction on a specific repurchase date. The currencies used in this transaction are mainly the widely traded. In every single contract, the Eurosystem and the counterparties agree on the “swap point” of transaction, that are the difference between the exchange rate of the forward transaction and the exchange rate of the spot transaction. The “swap points” of the euro towards the foreign currency are quoted according to general market conventions. To mitigate exposure to credit risk, liquidity risk and exchange rate risk, the best instruments that the ECB use, on the straight of Articles 18.1 of the Statute of ESCB (European System of Central Bank), are the assets use to the counterparties as securities. That Article establish that all the liquidity‐providing operations are based on underlying asset provided by the counterparties for suitable guarantee (eligible assets). The Eurosystem accepts a broad range of assets as collateral in all its credit operations. This feature of the Eurosystem’s collateral framework, together with the fact that access to Eurosystem open market operations is granted to a large pool of counterparties, has helped the ECB to supporting the implementation of monetary policy in times of stress. The flexibility of its operational framework has allowed the Eurosystem to provide the necessary liquidity to address the impaired functioning of the money market during the financial crisis, without counterparties encountering collateral constraints. The aim it’s protecting the Eurosystem from incurring losses in its monetary policy operations and ensuring the equal treatment of counterparties. To increase the efficiency and transparency not all the asset can be elected as guarantee, and from the 1 January 2007 the Eurosystem has developed a single framework for elegible assets common to all the Euro area credit operation. The asset are distinct in two classes, marketable and non‐marketable assets, but the only difference it’s that the non‐marketable assets are not used by the Eurosystem for outright transaction. Both type of eligible assets for monetary operation can also be used as underlying assets for intraday credit. The ECB has set up a “European Credit Assessment Framework ( ECAF) “ in order to ensure that all the assets used as collateral have to respect the Eurosystem’s requirement of “High credit standards”, and moreover established, maintains and published a list of eligible marketable assets, but only for collateral already issued. For be marketable or non‐ marketable, a collateral must respect some criteria :

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To ensure that the requirement of high credit standard for all eligible asset is met, the Eurosystem has created the Eurosystem credit assessment framework (ECAF). That framework defines the procedure, rules and technique for assessing the credit standard of eligible assets by using the information from credit assessment system belonging to one of four sources:
• ECAI – External Credit Assessment Institution
• ICASs – In‐house credit assessment system
• IRB – Internal ratings‐based
• RTs – rating tool
The aim of Eurosystem is establishing its “minimum requirement for high credit standards”. This benchmark is defined in terms of a credit assessment of credit quality step 3 in the Eurosystem’s harmonized rating scale, that means a PD (probability of default) over a 1 year horizon of 0.40%. Otherwise, with regard to asset‐backed securities, the Eurosystem’s benchmark for establishing its minimum requirements for high credit standard is defined in terms of a “triple A” credit assessment at issuance, over the lifetime of asset‐backed securities. To determinate the eligibility of this securities by the ECAI, issued on or after 1 March 2010, the “second best rule” is applied. That means, not only the best, but also the second‐best available ECAI credit assessment must comply with the credit quality threshold for asset‐backed securities. Based on this rule, the Eurosystem requires for both credit assessment an “AAA/Aaa” level at the issuance and a “single A” level over the life of the security in order for the securities to be eligible. Once established the eligible criteria for the assets, the ECB in order to protect the Eurosystem against the risk of financial loss if underlying assets have to be realized owing to the default of a counterparty, applied a series of risk control measure. The ECB applies specific risk control measure according to the types of underlying asset, marketable and non‐marketable, offered by the counterparty. This risk control measure are broadly harmonized across the euro area and ought to ensure consistent, transparent and non‐discriminatory conditions for any type of eligible asset across the Euro area.
The risk control measure applied by Eurosystem are:
1. Valuation haircuts – applied in the valuation of underlying assets, implies that the value is calculated as the market value of the asset less a certain percentage (haircut)
2. Variation margins (marking to market) – The Eurosystem requies the haircut‐adjusted market value of the underlying assets used in its liquidity‐providing reverse transaction to be maintained over time. This implies that if the value, measured on a regular basis, of

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underlying assets falls below a certain level, the NCB will require the counterparty to supply additional assets or cash.
3. Initial margins – the Eurosystem may apply initial margins in its Open Market Operations, that means that counterparties would need to provide underlying assets with a value al least equal to the liquidity provided by ECB plus the value of the initial margin
4. Limit in relations to issuer/debtors or guarantors – the ECB may apply additional limits, other than to the use of unsecured debt instruments, to the exposure towards issuer/debtor or guarantors.
5. Application of supplementary haircuts – if required to ensure adequate risk protection of Eurosystem
6. Additional guarantees ‐ the Eurosystem may require additional guarantees from financially sound entities in order to accept certain assets
7. Exclusion – the ECB may exclude certain assets or specific counterparties from its monetary policy operation, because sometimes the credit quality of the counterparty appears to exhibit a high correlation with the credit quality of the collateral submitted by the counterparty.
2.1 ‐ Data for 2011 on the eligible assets for credit operation
Since 1 January 2011 the policy of ECB about which type of assets the counterparty of Open Market Operation can used as collateral has undergone some changes. The fixed‐term deposit previously excluded, can be used as collateral in the Eurosystem’s standard framework. However, these instruments had already been accepted as eligible collateral, following the temporary expansion of the list of eligible collateral in 2008. In addition, at its meeting on 8 December 2011, the Governing Council decided, in connection with other non‐standard monetary policy measures, to increase collateral availability. In 201114 the average amount of eligible collateral was declined, compared with 2010, to €13.2 trillion. The decrease of 6% was related in particular to a significant decrease in uncovered bank bonds, mainly owing to the expiry of some of the state guarantees on unsecured bank bonds, as well as in asset‐backed securities (ABSs), which are largely attributable to tighter rating requirements implemented as of 1 March 2011.
14 European Central Bank - Annual Report 2011

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Chart 1 – Collateral put forward in Eurosystem credit operations versus aout standing credit in monetary policy operations
Chart 2 – Breakdown of assets (including credit claims) put forward as collateral by asset type
Central government securities, which amounted to €6 trillion, accounted for 46% of total eligible collateral, followed by uncovered bank bonds (14%) and covered bonds (12%) . The average amount of collateral put forward by counterparties decreased to €1,790 billion in 2011, from €2,010 billion in 2010 . At the same time, the average amount of outstanding credit also decreased, by approximately €137 billion compared with the previous year, partly as a result of the expiry of one‐year LTROs towards the end of 2010. Consequently, the share of deposited collateral not used to cover credit from monetary policy operations increased during 2011, whereas the absolute amount decreased slightly. This suggests that, at least at the aggregate level, the Eurosystem’s counterparties experienced no shortage of collateral. As regards the composition of collateral put forward (see Chart 2), non‐marketable assets (mostly credit claims and fixed‐term deposits) became the largest component in 2011, accounting for 23% of the total (compared with 18% in 2010). On the other side developments in total eligible collateral, the shares of ABSs and uncovered bank bonds decreased. By contrast, also owing to the sovereign debt crisis in some euro area countries, the average share of central government bonds increased slightly from 13% in 2010 to 14% in 2011.

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3 ‐ Sovereign exposure of the banks – How the credit risk is transfer to central banks
The crisis has underlined the strong interdependence between the euro‐area banking and the sovereign crises. This is not a specific feature of Europe, but the vicious cycle seems to be particularly strong compared to the rest of the economies. The reason why euro‐area banks and sovereign seem to be indissolubly tied together are more, analyze the main one15 :
1. Unlike the USA, the euro‐area don’t have a supranational banking resolution framework. Therefore the member states remain be responsible for the rescue of their national banking system, and given the size of the banks, the fiscal consequence of banks rescue could be extremely harmful.
2. The domestic banks hold in their balance sheet a considerable share of national government debt. The reason is possible twofold. First, this means that the European financial system remain largely bank‐based because the banks play a key intermediary rule that is some extended mirrored by the size of their assets. Second, government bonds are appealing because they can be easily used as collateral, on the interbank market in normal times and for central banks emergency lending in trouble times. The reason is because the Basel regulatory framework allows a for the zero‐rating weighting of bond issued by euro area governments.
But today the problem is that highly rated sovereign are still low‐risk assets but they are no longer perceived as risk‐free, they are no longer zero credit assets. In term of risk management, it’s important to distinguish between credit risk (default risk) and credit spread risk. Credit risk reflects the risk of potential credit losses due to a counterparty default event, or a credit migration event like a downgrade from one rating grade to another. Credit spread risk, which is part of the market risk incurred by a bank, arises from the possibility that changes in credit spreads will affect the value of financial instruments. Credit spreads represent the credit risk premiums required by market participants for a given credit quality (e.g., the additional yield that a debt instrument issued by a AA‐rated entity must produce over a risk‐free alternative). There are many instruments that can be used to manage this type of risk. Swaps and options, for example, can be designed to mitigate losses due to changes in credit spreads, as well as the credit downgrade or
15 S.Merler and J.Pisany-Ferry – Who’s afraid of sovereign bonds? – Brugel policy contribution , February 2012

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default of the issuer. Both credit risk and credit spread risk are reflected in the sovereign spreads measured in the bond markets and in the CDS markets, that means sovereign assets are no more no longer risk‐free assets, but have become spread products or credit products. For this reason the “markets are questioning the risk‐free status of debt issued by a number of number of government worldwide. This morphing of sovereign debt from a risk‐free into ‘credit risk’ instrument has far reaching implications, not least for the amooth functioning of financial system. It creates adverse feedback effects on financial institutions and, in particular, it magnifies counterparty credit risk and creates significant funding challenges for banking systems.”16
But these considerations are not sufficient to explain why banks’ balance sheet are loaded with government debt, probably some reasons have to be search in more or less form of pressure on banks exercised by the Governments. Indeed, if we analyze how is changed observing the evolution of holding of government debt held at first from non‐residents and after held by domestic banks. From the start of sovereign crises the holding of government debt by non‐ residents have diminished in proportion for all the countries in trouble ( GIPSI countries ‐ Greece, Ireland, Portugal, Spain and Italy), consequently the share of domestic sovereign debt held by domestic banks increased significantly between 2007 and 2011 in all countries with bonds that have been stunned by non‐residents (GIPSI countries) remained roughly stable in France and Netherlands, and decreased in Germany. Merler and Pisany‐Ferry17 suppose that this can be interpreted as a new wave of “financial repression” , see for example, President Sarkozy’s public suggestion that banks should use the ECB liquidity to buy more sovereign bonds.
Given the relevance of the link between sovereign and banking stress, most of the literature is focus on the channel through which a deterioration in the creditworthiness of a sovereign can have an impact on banking system. The most relevant channel are18 :
• Banks’ holding of sovereign government debt have a negative impact on banks’ assets in case the sovereign has problem
• Higher sovereign risk reduces the value of collateral that can be used for founding
• Sovereign downgrades normally translate into lower ratings for banks located in the downgrades country
16 J Caruana, “Basel III: New strains and old debates – challenges for supervisors, risk managers and auditors”, speech delivered at the Bank of Portugal conference, Lisbon, 14 October 2011.
17 S.Merler and J. Pisany-Ferry – Who ‘s afraid of sovereign bonds? - Brugel Policy contribution, February 2012
18 C.Angeloni and Guntram B.Wolff – “Are banks affected by their holdings of government debt ?” – Brugel working paper 07/2012

26. • Increased sovereign risk reduces the value of the implicit/explicit governments guarantee to banks
The financial crisis and global economic downturn have caused a sharp deterioration in public finances across advanced economies, especially the euro crisis has revealed how the interdependence between sovereign and banks can weaken both sides, and whole monetary union as a consequence. The first negative implications are in the banking system. Since the bank bailout of 2008‐09, market participant have priced sovereign and banking default risk as closely intertwined, as showed by the follow graphs that illustrate the malign feedback between weak sovereign and banking system.
This situations is currently most severe in some euro area countries, which have seen their credit ratings lowered several notches and/or have increased their debt spreads, like Greece, Ireland and Portugal that have received international assistance, after they were unable to raise funding at reasonable cost. But also, elevated sovereign debt levels in advanced countries may means that their debt is no longer regarded as having zero credit risk and may not be liquid at all times. As a result, sovereign risk premia could be persistently higher and more volatile in the future than they have been in the past, particularly for less fiscally conservative governments, and this will almost certainly have adverse consequences for banks. Sovereign ratings are important for banks also because represent a ceiling for the rating of domestic banks. As at end‐201019, only 2% of domestic rated banks (three out of 172) across seven non‐AAA European countries had a rating (from any of the three major rating agencies) that was higher than that of their respective 26
19 C.Angeloni and Guntram B.Wolff – “Are banks affected by their holdings of government debt ?” – Brugel working paper 07/2012

27. sovereign. Rating downgrades generally cause banks to pay higher spreads on their bond funding, and may also reduce market access. Moreover, institutional investors that are restricted to investment grade bonds could be forced to liquidate their holdings of bank bonds if their ratings fall below this threshold. In the opinion of Correa20 (2011) sovereign downgrades in advanced countries and emerging economies had a significant effect on banks’ equity financing costs: on average, a one‐notch downgrade reduced bank equity returns by 2 percentage points in advanced countries, and by 1 percentage point in emerging economies. To fortify this phenomenon, we can use some data of Fitch rating agency, that show how the bank rating methodology used by credit rating agencies takes into account not only a bank’s standalone credit profile but also the prospect of government support in times of stress. As shown in graph , rating upgrades that reflect implicit government support have increased since 2007. This means that credit rating agencies are still inviting investors to price in a large degree of public support for large banks , and this despite any “no bailout” policy stance that denies the use of public funds to rescue “too big to fail” institutions.
This graphs show how the sovereign debt concerns have pushed up banks’ founding cost, especially banks from the peripheral euro area, but also banks in the other advanced countries, where the deterioration of public finance conditions is less pronounced, have experienced some funding cost pressure. The main reason concern the collateral/liquidity channel. Sovereign securities are used extensively by banks as collateral to secure wholesale funding from central banks, private repo market and issuance covered bonds, and to back OTC derivate position. Increases in sovereign risk reduce the availability or eligibility of collateral because when the price of a sovereign falls, the value of the collateral pool for institutions holding that asset automatically shrinks. A downgrade could even exclude a government’s bonds from the pool of collateral eligible 27
20 Correa (2011) – The impact of sovereign credit risk on bank funding cost – BIS , July 2011

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for specific operations or accepted by specific investor. The major determinants of haircuts are collateral valuation uncertainty, market liquidity and credit risk and although usually the sovereign debt does not suffer these problem, in time of crisis, the authorities may also apply haircuts on these one. This affect the provision of central bank liquidity that is typically conducted through repurchase agreements or secured transactions. In the open market operations of the Eurosystem the 20% of transaction are secured by government bonds. This share likely reflects the fact that a wide range of collateral instruments are eligible with the central bank and that banks tend to use sovereign bonds in private repos, where only very liquid collateral is accepted.
In the 2012, after a modification of the rules on collateral acceptance by the Eurosystem, banks from severely affected countries like Greece, Ireland and Portugal, have increased their use of Eurosystem liquidity and made greater use of domestic governments bonds or government‐ guarantee banks bonds to collateralized this funding. This was possible only because this countries have agreed international financial support and adopted a fiscal consolidation plan approved by European Commission and the IMF, in liaison with ECB. Another market that is affected by the link sovereign rating‐banking system is the private repo markets and especially in the euro area, where the amount of outstanding repos in June 2010 was equivalent to 75% of GDP, with four five of the transactions collateralized by government bonds (ICMA 2010 ). This market is very sensitive to changes in the perceived riskiness of the collateral as a matter of fact that only the 1.5% of transactions were collateralized by Greek, Irish and Portuguese government bonds during the six months to December 2010.
4 ‐ Policy implications and conclusion
Developments since 2007 have increased the structural vulnerability of euro‐area countries, reinforcing the sovereign/banking crisis vicious cycle. The negative spillovers from sovereign risk to bank funding conditions and the extensive role of government securities in the financial system represent yet another reason to step up efforts to maintain sound public finance conditions. This crisis have show that it’s hard to fully insulate the banking system from distressed domestic sovereign, because the close links between banks and sovereign imply that the global financial stability depends on fiscal conditions in each individual country. The most relevant target of the

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advanced countries it’s to implement credible strategies to stabilized or reduce their debt levels, like new technical Italian government drive by Mario Monti. Because if governments do not return rapidly to sound fiscal policy, and the risk of their sovereign debt remain elevated, authorities should closely monitor the effects of regulatory policies which provide banks with strong incentives to hold large amounts of government securities.
Banks, especially in recent years and especially in Greece, Ireland, Portugal, Spain and Italy (GIPSI), have increased their exposure to their national governments, investing in government securities. This meant that in these countries, banks have become more "sensitive" to changes in the price of domestic government bonds, i.e. the price of their shares is reduced more when the price of the bonds of their country is reduced, because of concerns about the sovereign solvency. But this has, in turn, a perverse reflection of the assessment of national government bonds, because if the banks go on bankrupt is expected to be saved by their own government and that this should issue more debt. And so on, in a tremendous vicious cycle that led panic waves in the markets, that have taken place since the summer of 2010. A crucial problem is the prudential regulation of banks in the EU, that with its directive established the public debt of the European states should be considered as "risk‐free" for the purposes of the coefficients of capitalization of banks, ie they are required to set aside capital against their investments in government debt.
At the same time, banks are attracted by the possibility of profiting from higher interest rates on Italian or Spanish debt financing basis with a ridiculously low rates at the ECB, especially (but not only) after the launch of LTRO. And in doing this, the bank do not realize (or rather deliberately ignore) that the interest rate differential that they are earning is a reward for the risk they are taking. And also at the macro level, with these behaviors the bank increasing the fragility of the financial system, since they are reinforcing the potential vicious circle mentioned above. But of course that does not interest them. To support this thesis we can use the work of Gros and Mayer “without the immediate installation of any sovereign default mechanism such as a European Monetary Fund, the ECB risks to degenerate to the ‘Bad Bank’ of the euro area as timid investors are offloading sovereign bonds with uncertain repayment values on the ECB’s balance sheet. Although ever larger rescue packages have been prepared, investors clearly understand that some countries supported by the ECB’s Securities Markets Programme (SMP) these days will still have the potential to become insolvent. An increasing degree of political and financial dependence of the

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ECB is the dire consequence. Accordingly, we observed the exchange rate of the euro declining over the last weeks proportionally to the deterioration of the ECB’s balance sheet. Since there are
strong signs of perpetuation of the exit from the exit from unorthodox monetary policies in the euro area right now, the internal value of the euro will follow and shrink very soon which – in turn – will imply higher inflation in the long run (Belke 2009, 2010a and b, Gros and Mayer 2010).

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Reference :
• European Central Bank ‐ Annual Report from 1998 to 2011
• F.Panetta ‐ CGFS Paper N°43 – The impact of sovereign credit risk on bank funding conditions – July 2011.
• S.Merler and J.Pisani‐Ferry – Who is afraid of sovereign bonds ? – Brugel Policy contribution, February 2012
• C.Angeloni and Guntram B. Wolff – Are banks affected by their holdings of government debt ? ‐ Brugel working paper 07/2012
• H. Hannoun D.G.M. of BIS – Sovereign risk in bank regulation and supervision. Where do we stand ? ‐ Financial Stability Institute High‐Level Meeting , Abu Dhabi, UAE , 26 October 2011
• Guideline of the European Central Bank, 20 September 2011 ‐ monetary policy instruments and procedures of the Eurosystem (ECB/2011/14) (2011/817/EU)
• The European Central Bank, The Eurosystem and the European System of Central Bank – Official document 2009
• Consolidated Version of the treaty on the Functioning of the European Union – official journal of the European Union 30.03.2010
Website used (obviously also the additional links contained in this websites have to be consider):
1. http://www.ecb.int/ecb/html/index.it.html
2. http://www.ecb.int/mopo/intro/objective/html/index.en.html
3. http://www.bancaditalia.it/eurosistema/esrb
4. http://www.bancaditalia.it/eurosistema
5. http://www.bancaditalia.it/banca_centrale/polmon/obiettivi
6. http://placeduluxembourg.wordpress.com/2012/03/02/ecb‐market‐intervention‐the‐ securities‐market‐programme‐smp/
7. http://www.ecb.int/mopo/liq/html/index.en.html#portfolios
8. http://www.ecb.int/pub/pdf/other/gendoc98it.pdf
9. http://www.voxeu.org/index.php?q=node/7059
10. http://www.ecb.int/paym/t2/html/index.en.html

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