Wednesday, January 07, 2015

European Central Bank was confused about lender of last resort role in 2008

Bank of England Committee of Non-Executive Directions meeting 10 September 2008 (page 297)

ECB investigation 

It was reported that the ECB was undertaking an investigation into whether any central bank action over the recent period had breached Article 101 of the EU treaty, in providing financing that should have been provided by government, and therefore amounted to finance to government. It was explained that the ECB was the legal authority that had a duty under the Treaty to monitor compliance with Article 101. Therefore ECB officials needed to apply a procedure to investigate all countries in an even way. 

As part of the investigation, the ECB had made a very broad request for information and documents, including Court papers. The Bank had instead supplied a statement about what had happened, and offered to answer further questions. Legal documents setting out the terms of the facilities provided for Northern Rock and the state aid material had also been provided. The Bank had not sent any internal papers or conceded the ECB's right to these. It was noted that, even if the ECB disagreed with what had been done, it was likely that it would only be able to criticise the UK authorities for not having transferred the lending to the Treasury when Northern Rock had been nationalised or earlier. There were good arguments for HM Treasury having phased the repayments rather than having to issue gilts rapidly following their clear statements of intent. 

However, it was stated that the ECB had the right to take a central bank to the European Court for breach of the monetary financing prohibition. This was relevant to the Bank's future role as the Special Resolution Authority. 

The Governor had spoken to the ECB President to ensure an overly legalistic interpretation of Article 101 did not inhibit financial stability operations or circumscribe what the Bank could do as the Special Resolution Authority. It was explained that Article 101 had originally been framed to ensure national central banks did not buy government debt as part of the need to anchor fiscal discipline within monetary union. It had never been designed with lender of last resort or special support operations in mind. Mr Trichet had agreed with that distinction.

From an ECB legal opinion during this same period --

The provision of emergency liquidity assistance is a central bank function, which consists in giving support in exceptional circumstances and on a case-by-case basis to temporarily illiquid but solvent credit institutions. However, it is the ECB’s view that ‘national legislation foreseeing the financing by NCBs of credit institutions other th an in connection with central banking tasks (such as monetary policy, payment systems or temporary liquidity support operations), in particular to support insolvent credit and/or other financial in stitutions, is incompatible with the monetary financing prohibition.’ 

The news here is as follows.

1. At the height of the financial crisis, with central banks reaching deep into the toolbox as lenders of last resort to prevent the banking system from imploding, the European Central Bank was hounding all EU central banks about whether they were financing insolvent banks.

2. The central banks probably were financing insolvent banks, including in Ireland, but it was very hard to tell so at the time.

3. Jean-Claude Trichet told the Bank of England that yes, yes, he understood the distinction between central banks giving money directly to governments (bad) and central banks engaging in operations to prevent banks from collapsing (good), but when it came to actually writing legal opinions, it saw no such distinction -- both bad.

4. This may explain why Ireland was so keen to come up with non-bail out options during this period, and went instead for the disastrous guarantee. Of course the Article 101 blow-up would come 2 years later.