The European Central Bank’s consolidated balance sheet is six times larger than before the 2007-08 financial crisis. Nevertheless, we are witnessing calls for euro area central banks to maintain large balance sheets, with considerable excess liquidity in banking markets, and not completely wind down their large-scale holdings of government and corporate bonds.
Crisis measures would then become permanent. Banks, corporates and sovereigns would be – at least partially – shielded from the salutary discipline of market pressures. Moreover, such a policy could endanger the ECB’s independence. This confirms the concerns of those who warned at the start of the bond-buying programmes that they would be risky and difficult to exit.
The substantial rise in the balance sheet mainly reflects the Eurosystem’s large-scale purchases of bonds from commercial banks, which were then credited with the equivalent amounts in their central bank accounts. As a result, on average throughout the euro area, banks’ reserves in ECB accounts exceed 23-fold the volume needed to fulfil their banking functions.
Unlike in pre-crisis years, banks no longer have to borrow central bank money from other banks if they are short of funds. The interbank market is largely non-functioning. The requirement for operational soundness to maintain creditworthiness has been attenuated, amounting to a de facto subsidisation of weak banks.
The scaling back of market pressure extends to public budgets, too. If central banks permanently hold a considerable proportion of sovereign bonds, finance ministers become less dependent on private investors and their desire for sound public finances. Central bank deposits are used to finance bonds purchased from the banks. So considering a combined central bank and government balance sheet, government debt ultimately bears interest at the same rate – the ECB deposit rate. This support is of particular benefit to highly indebted countries.
For this part of government debt, governments’ financing costs rise on a one-to-one basis if the central bank increases its key interest rates. To prevent a higher national debt burden, politicians may be tempted to put pressure on their central bank to raise interest rates by less than would be necessary in terms of monetary policy.
Threats to independence
In an extreme case, the central bank is caught in a near-irresoluble dilemma. Either it disregards its price stability mandate and counters a destabilising increase in government financing costs by further massive government bond buying regardless of the inflation outlook, or it risks a sovereign debt crisis.
Put differently: long-term bonds on the assets side of its balance sheet are balanced by short-term interest-bearing surplus reserves. Owing to this maturity mismatch, which did not exist before the bond purchases, a tightening of monetary policy leads to high losses, as is currently the case at the Bundesbank. These losses are ultimately passed on to taxpayers through the lack of central bank profits. The monetary policy debate can then become unhealthily politicised.
To ensure that a central bank does not prioritise the solvency of the sovereign over its primary mandate of price stability, the European treaties prohibit monetary state financing. In its public sector purchase programme ruling of 5 May 2020, the German constitutional court stated that this prohibition had not been obviously circumvented because ‘acquired debt instruments are to be returned to the market if continued intervention is no longer necessary to achieve the inflation target’. However, that stipulation would not be upheld if central banks continue to maintain government bonds on a large scale over the long term.
Arguments for a large balance sheet disregard legal and economic concerns
The supporters of a big ECB balance sheet largely disregard these legal and economic concerns. Instead, they emphasise the alleged advantages of permanently high central bank balances – for example in a financial crisis.
However, in the event of a crisis, it would be sufficient for the ECB to provide banks with generous liquidity as a lender of last resort. Banks do not have to hold permanent volumes of excess liquidity for reasons of financial stability. In the same way, homeowners do not keep large sums of money in their current accounts to rebuild their houses after a fire. Instead, they take out fire insurance.
Another argument used in favour of a large ECB balance sheet is that banks’ demand for central bank reserves allegedly fluctuates more than in the past. High excess reserves could, it is claimed, prevent this instability from affecting money market rates and ultimately destabilising the economy. But this instability is itself largely created by the inoperability of the interbank market – caused by over-abundant central bank balances.
Stabilising demand for central bank money
The solution to these self-created problems cannot be a permanently large balance sheet. Instead, what is needed is a return to a lean balance sheet with scarce central bank reserves. The demand for central bank money would become more stable over time.
It is not justifiable to argue that a permanently large ECB balance sheet and high surplus liquidity are needed to maintain bank lending to companies and households. Reducing long-term ECB refinancing instruments with favourable interest rates for banks that meet certain lending requirements may initially lead to somewhat lower loan volumes. But in the medium term, banks can switch to other sources of financing such as bank bonds, which incidentally strengthens competition in the banking sector. With well-functioning capital markets, profitable investment opportunities will always attract sufficient capital.
The arguments in favour of a large ECB balance sheet with high excess liquidity are not convincing. The ECB should gradually return to a balance sheet that provides the banking system with a sufficient volume of assets needed for efficient functioning.
An intelligent mix of refinancing transactions with different maturities, combined with a complete dismantling of bond holdings, could bring the Eurosystem balance sheet to the right level. Commercial banks would gradually become reaccustomed to a world without abundant excess liquidity. The financial sector needs the discipline of market forces. A decade and a half after the financial crisis, the ECB should return to greater normality.
Jens Weidmann is Chairman of the Supervisory Board and Jörg Krämer is Chief Economist at Commerzbank. Weidmann was President of the Deutsche Bundesbank from 2011-21.
This is a translated and edited version of an article in Welt am Sonntag on 14 January.