The European Central Bank Collateral Volume: Huge, Growing and Self-rated

The amount of collateral that is posted at the European Central Bank (ECB) is huge. And it is growing. The figures are reported by the ECB. Also, they are analyzed and assessed in a new BIS study, Central Bank Collateral Frameworks and Practices (March 2013).

The picture below shows the sheer volume of the collateral posted at the ECB. Since 2004 it has more than tripled to a value of EUR 2,478 bln at the end of 2012.

ECB Collateral Volume, source: ECB

ECB Collateral Volume, source: ECB

We can also conclude that the eligibility criteria have been relaxed since 2004. E.g., the relative size of government securities has decreased from 38% in 2004 to 19% in 2012. During the same period the amount of non marketable assets has increased from 4% to 26%. So more than a quarter of the collateral posted at the ECB consists of less liquid assets such as fixed-term deposits from eligible counterparties, credit claims and non-marketable retail mortgage-backed debt instruments (RMBDs). The ECB does not publish a list of eligible non-marketable assets. The National Central Banks are responsible for determining the eligibility of these assets.

Since the Global Financial Crisis the Eurosystem has used the collateral in its non-conventional easing (outright purchases, collateralized term lending), resulting in large-scale lending. However, the size of the collateral pool tends to exceed the actual use.

Also, the acceptance of less liquid collateral is associated with stressed market conditions in which some counterparties have a greater need to access central bank liquidity after the ability to obtain market funding has vanished. In its “differentiated” collateral framework, the Eurosystem is able to increase the interest rate of the funding that is provided to suppliers of less liquid collateral.

What new insights are provided by the March 2013 BIS publication on Central Bank collateral frameworks? And what conclusions and concerns can we point out related to the huge collateral pool?

Some explanations

The paper offers some explanation regarding the modification of the collateral framework of the ECB and other central banks. Due to the Global Financial Crisis, the central bank collateral frameworks tend to be broader than before 2008, leading to an acceptance of more asset types. The ECB is certainly no exception to this trend, given the increase of non-marketable assets on the ECB’s collateral pool (both in absolute and relative terms). The Eurosystem currently still has a number of “temporary measures” in place such as the acceptance of some Asset Backed Securities with lower initial ratings.

The study finds that the acceptance of less liquid collateral tends to be associated with “lending with more penal pricing”. This circumstance is linked to a “differentiated framework” for collateral quality and the Bagehot principles of Central Banking that state that the Central Bank should lend lavishly, use good collateral, and price the collateral according to its quality (“free lending”, “good collateral”, “penalty rates”).

The amounts reported in the figure above are collateral values after haircut. The trend is that central banks want to reduce their “mechanistic reliance” on ratings provided by the rating agencies. Instead, they are developing this knowledge internally. As the study points out, this is in line with the principles of the Financial Stability Board (2010) that require central banks to reduce their reliance on external credit ratings and to reach their own credit judgment. The Eurosystem explicitly reserves the right to assess the credit quality of assets on the basis of any information it may consider relevant.

The same tendency to move away from the “mechanistic reliance” on external credit ratings can also be found in the revised Basel securitization framework (December 2012).

Bagehot or pledging the kitchen table

Whether or not the huge collateral volume and its pricing follow Bagehot’s principles is subject to dispute. Forbes’s reporter Louis Woodhill states in this regard:

Note that the role that is being proposed for the ECB is the exact opposite of Bagehot’s description of a lender of last resort.  The ECB is being pressured to fund insolvent governments, against worthless collateral, at below-market interest rates, and, in so doing, set itself up for huge financial losses.

The interesting point is that collateral mispricing need not be restricted to the less liquid asset types. The phenomenon could as well be applicable to EU Member State sovereign debt that continues to receive 0% RWA. A clear denial of the sovereign risk.

A related concern is that, thanks to the Eurosystem’s collateral expansion, some peripheral banks pledge less liquid assets at the ECB in return for cash that they use to buy up high yielding sovereign debt. Rabobank rate strategist Richard McGuire said about this practice in February 2012:

If you can effectively pledge the kitchen sink you could see a fairly significant take-up.

When looking at the collateral volumes and their breakdown, we fear that this is exactly what has happened.

Mechanistic reliance on credit ratings

Of course, it is a good development that ECB and the National Central Banks develop their own rating assessments. However, in order to do so, they need high-quality data. The ECB has launched its European DataWarehouse (ED) and banks have to submit their RMBS data to this ED in return for their eligibility. At this moment, there are still many hurdles for an adequate data transfer of pool information to the ED, as Reuters reports on April 5, 2013:

Submitting unified clean data matching the ECB’s templates still has some hurdles. Spanish banks, for example, that have been merged rapidly into large groups may still have incompatible mortgage data systems. Even one large UK institution was said to have spent GBP5m preparing to provide loan data in the form demanded by the Bank of England.

Also for unpackaged loans that are posted as collateral, operational problems exist. The national banks of Spain and France are reported to apply smaller than usual haircuts on collateral posted by lenders. ECB president Mario Draghi says about this news:

We take these incidents very, very seriously.

And they should. Banks are supposed to determine their collateral value in a conservative way, according to EBA principles:

Recommendation 9 In order to ensure sound collateral management institutions should:

(…)

– have an overall policy, approved by senior management, that includes a conservative definition of collateral and specifies the level of unencumbered collateral that should be available at all times to face unexpected funding needs;

Of course, the conservative definition of collateral applies to the ECB as well and reports about the ECB’s own problems with collateral management are not helpful.

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Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

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