TARGET2

• By Stefano Corradin, Marie Hoerova and Glenn Schepens[1] Many central bank measures implemented in past years most recently the additional longer-term refinancing operations launched by the Eurosystem at the onset of the COVID-19 pandemic aimed inter alia at safeguarding money market conditions.
• This is because smoothly functioning money markets are key for the transmission of monetary policy to credit conditions in the economy.
• In this article we look at money market conditions in the euro area over the past 15 years and discuss the interactions between money markets, central bank policies and new Basel III regulations.

Introduction

• Banks, non-bank financial institutions and non-financial corporations rely on money markets for their short-term funding and collateral needs.
• Well-functioning money markets are important for the transmission of monetary policy impulses to credit conditions as money market rates serve as benchmark rates for the pricing of credit.
• To ensure that the transmission is smooth, it is important that money market rates are in line with central bank policy rates.
• In the euro area, money markets went through substantial changes and turbulent periods over the past 15 years.
• Second, there was a shift away from unsecured money markets towards secured money markets (see for example De Fiore, Hoerova and Uhlig (2019)).
• Prior to 2015, financial stress tended to worsen money market conditions, while higher central bank liquidity provision was associated with improved money market conditions.
• Going forward, money market developments should be monitored, as factors affecting money market activity may change.

Measuring euro area money market activity

• To measure money market activity, we consider several metrics of activity in both secured and unsecured euro area money markets: volumes, i.e.
• euro amounts traded in money markets; rates; and the dispersion index of money market rates.
• Dispersion of money market rates as set out by Duffie and Krishnamurthy (2016) is a measure of how far individual money market rates diverge from the average rate, and combines information contained in money market rates and volumes.
• It is measured as the weighted mean absolute deviation of the cross-sectional distribution of the 1-day money market rates, based on a euro area average for unsecured rates and on four large euro area countries (Germany, France, Italy and Spain) for secured rates (see Chart 1).

Chart 1

Cross-sectional dispersion of 1-day money market rates, 2005-2020
• There are two specific channels through which money market rate dispersion may matter for central banks.
• First, money market rate dispersion can be a sign of market segmentation that is generally associated with counterparty risk, imperfect competition, regulation, or trading frictions.
• A high degree of money market segmentation may impair banks ability to trade in money markets and lead to an increased demand for central bank liquidity.

Euro area money markets over the past 15 years

Looking back over the 2005-2020 period, our analysis documents that euro area money market conditions tend to worsen if financial stress increases, or if central bank asset purchases induce scarcity effects by withdrawing valuable collateral assets from the money markets. In addition, dispersion of money market rates tends to rise at quarter- and year-ends, when banks report various regulatory statistics.

Interactions between money markets and financial stress

• With regard to financial stress, before 2015, dispersion across money market rates tended to be high during crisis periods and was positively related to the VSTOXX index, a proxy for financial market volatility (Chart 2).
• Money market volumes decreased with higher financial stress, pointing to an overall decrease in money market activity.
• After 2015, the evolution of the dispersion index was no longer tightly linked to financial market stress.
• The reason behind a relatively muted reaction of 1-day money market rate dispersion was a swift and broad-based reaction by the Eurosystem to stabilise financial markets.

Chart 2

Cross-sectional dispersion of 1-day money market rates and financial stress, 2005-2020

Interactions between money markets and central bank policies

• Before 2015, dispersion of 1-day money market rates was negatively related to Eurosystem liquidity provision suggesting that central bank liquidity provision is associated with lower money market tensions (Chart 3).
• This is consistent with evidence presented in Garcia-de-Andoain, Heider, Hoerova and Manganelli (2016) who documented that liquidity provision by the Eurosystem during the financial and sovereign debt crises stimulated the supply of liquidity in the unsecured money markets, especially to banks located in stressed countries during the euro area sovereign debt crisis.

Chart 3

Cross-sectional dispersion of 1-day money market rates and excess liquidity, 2005-2020
• During 2015-2016, our results indicate an increase in the money market rate dispersion index, without an accompanying increase in financial market stress (Chart 2) and while excess liquidity levels were high, primarily driven by the Eurosystems Public Sector Purchase Programme (Chart 3).
• Central bank asset purchases withdraw government bond collateral from the financial system and government bonds are the main type of collateral used in secured money markets.
• The dispersion decreased again after the easing of the terms of the Securities Lending Programme in December 2016 (Chart 4).
• The Securities Lending Programme was initially only sparsely used.
• Only when the Eurosystem introduced the cash-collateral option which allowed accepting cash - not only bonds - in return for lending bonds, did securities lending increase.

Chart 4

Cross-sectional dispersion of 1-day money market rates and securities lending, 2015-2020

Interactions between money markets and new Basel III regulations

• We further study how new Basel III regulations, such as the Leverage Ratio (LR) and the Liquidity Coverage Ratio (LCR), affected money market activity.
• These regulations started being phased in (in the case of the LCR) or publicly reported (in the case of the LR) as of 2015 (Chart 5).
• We document that the LR requirement led to reduced borrowing, higher rates and increased dispersion in money market rates at quarter-ends, i.e.
• We do not find evidence of month-end effects, suggesting that LCR requirements which are reported by banks at the end of the month have not had a significant effect on euro area money markets so far.

Chart 5

Cross-sectional dispersion of 1-day money market rates and regulation, 2005-2020

Concluding remarks

• We did not find evidence that liquidity requirements affected money markets significantly so far.
• This may be due to the large Eurosystem balance sheet size, which facilitated the fulfilment of liquidity requirements through the ample supply of central bank liquidity.
• Going forward, money market developments should be monitored, as factors interacting with money market conditions may change.
• Unlike banks, these participants may not have access to operations with the central bank.

References

• Altavilla, C., G. Carboni, M. Lenza, and H. Uhlig (2019), Interbank rate uncertainty and bank lending, ECB Working Paper No 2311.
• Arrata, W., B. Nguyen, I. Rahmouni-Rousseau, and M. Vari (2020), The scarcity effect of QE on repo rates: Evidence from the euro area, Journal of Financial Economics, 137(3), pp.837-856.
• Brand, C., L. Ferrante and A. Hubert (2019), From cash- to securities-driven repo markets: The role of financial stress and safe asset scarcity, ECB Working Paper No.
• 2232.
• Corradin, S., Eisenschmidt, J., Hoerova, M., Linzert, T., Schepens, G., and Sigaux, J-D. (2020), Money markets, central bank balance sheet and regulation, ECB Working Paper No.
• (2020), The importance of being special: Repo markets during the crisis, Journal of Financial Economics, Vol.
• De Fiore, F., M. Hoerova, and H. Uhlig (2019), Money markets, collateral and monetary policy, ECB Working Paper No.
• (2016), Passthrough efficiency in the Feds new monetary policy setting, In Designing Resilient Monetary Policy Frameworks for the Future.
• Federal Reserve Bank of Kansas City, Jackson Hole Symposium, pp.