Download The European Central Bank — History, Structure, and the Decision

The European Central Bank —
History, Structure, and the Decision
Making Process
Radek Foukal
Introduction
The European Central Bank (ECB) plays a major role in the European
Union’s economy as a whole. It is significant to recognize the start, and
development over the past decade, of the ECB. Central banks are
important in many economic aspects such as issuing bank notes,
changing interest rates and controlling money supply to keep liquidity
in the market. All these factors are prepared and managed by the three
bodies of the ECB: the governing council, which formulates the
monetary policy; the executive board, which implements the ECB
decisions, and finally the general council, which executes decisions with
all the national central banks of the European Union (EU). The ECB’s
main focus is on the price stability (inflation) and interest rates;
therefore, the whole process of policy making, which includes
preparations, discussions, decisions, communication, and
implementation, is the key of making an appropriate monetary policy.
Well managed banking is surely one of the most important
parts of every country’s economy. There are many institutions in the
economy that need to be managed, including commercial banks,
investment banks, and other large financial institutions. Management of
those entities of the economy requires some institution that will be in
charge. There is an institution that is designed to be in this special
position; that is a central bank. In recent history and the present, central
banks play major roles in real-world monetary systems.
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The Various Roles of the European Central Bank
There is one independent central bank that oversees not just one
economy but 27 of them. The ECB is located in Frankfurt, Germany.
The Central Bank operates as the main central bank for all European
Union members. First, the question is what makes an institution a
central bank? According to White (1999), economists have identified at
least six major roles for central banks, and they include:
1. Serving as a bankers’ bank
2. Having a monopoly of note issue
3. Acting as a lender of last resort
4. Regulating commercial banks
5. Conducting monetary policy
6. Managing the currency exchange
The role of serving as a bankers’ bank could be described as an
institution whose liabilities are held by commercial banks as part of
their reserves. Bankers’ banks can be also an economic device for
interbank money transfer. According to Goodhart, the typical central
bank gained its role of being a bankers’ bank over time (White, 1999).
A central bank was in a privileged legal position (as will be discussed),
as banker to the government in note issuing which brought about a
degree of centralization of reserves within the banking system, leading
to the role as bankers’ bank. Also the fact that a central bank was
supported by its home country government, gave it more power and
stability in that bankers’ bank position.
Monopoly of currency issue is another privilege of central
banks. In this case the ECB supplies bank notes into the Euro Zone,
though the euro coins are minted by the Euro Zone members. The fact
that central banks have a monopoly in issuing notes creates a lot of
responsibility for them and this is especially true for the ECB because it
issues notes for sixteen countries in the Euro Zone. The basic tenet of
currency issue is that if the central bank issues too many notes, it will
most likely lead to inflation; however if there is not enough liquidity in
the market it can lead to a liquidity crisis.
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Besides being a monopoly in issuing bank notes, central banks
have “secondary functions” of holding the banking system’s outside
money reserves and having the power to exercise control over credit
markets. Economic analysis has found that a monopoly of note issue is
not a natural monopoly, the product of economies of scale, but rather
the product of legislation. It comes into being as the result of
government and there is no reason to believe a single commercial bank
or any other type of bank would acquire a monopoly of note issue
absent government intervention. The ECB is not owned or supported by
any individual government; rather it is a private institution, endowed
with its position by the European Union.
The banking industries in the United States and Europe are
somewhat similar: there are both very large banks and many smaller
banks. The central bank function of regulation of commercial banks is
necessary because these private institutions are such a large part of the
economy. In these days in both the United States and Europe, it has been
suggested that the largest commercial banks should be regulated more
thoroughly than others, because as economists say “they are too large to
fail.” Basically what it means is if they were to go under the whole
financial system will go under. Another reason why banks should be
regulated is because it increases consumer confidence so that they are
more inclined to invest in what they perceive to be a more secure
financial system.
The ECB is not obligated to act as a lender of last resort but
large integrated economies such as the European Union need to be
running smoothly, because other countries around the world might be
dependent on that stability. Should a bank run into problems that
require it to borrow, and that borrowing cannot be satisfied in private
markets, the ECB may find that making credit available to that bank is
preferable to allowing the instability that might result from insolvency.
By not being required to act as lender of last resort, the ECB has the
ability to exercise judgment concerning which banks should be
supported and which might be beyond help.
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The monetary policy role of central banks plays an increasingly
important role in this international economy. The ECB uses monetary
policy to regulate the economy, through its influence on high powered
money and interest rates. High powered money, also known as the
monetary base, is defined as the currency held by the public and
reserves, that is vault cash held by banks and deposits of the banks held
in the central bank. Commercial banks can control the inflow and
outflow of commodity money; however they cannot control the quantity
of high powered money and that is why every country’s financial system
has a central bank that controls the main components in the system
(Mishkin, 2006).
The Evolution of the ECB and the Euro Zone
The ECB was established in June 1998 in Frankfurt, Germany. The ECB
formally replaced the EMI (European Monetary Institute) by virtue of
the Maastricht Treaty; however it did not exercise its full powers until
the introduction of the euro on 1 January 1999, signaling the third stage
of the development of the European Monetary Union (EMU). The EMU
was designated in its design to have one central bank, a free trade zone,
and one currency within the EU. The basic idea of the EU is to integrate
member countries economically and politically.
In order to have such a diverse union, there are certain rules
that need to be passed. According to the ECB the conditions to be fulfilled
before entering the EU are the Copenhagen criteria which require that
entering countries must have stable institutions guaranteeing democracy,
the rule of law, human rights, including respect for and protection of
minorities, and each country must have a functioning market economy
with the capacity to cope with competitive pressure.
Just as in many politically and economically unionized
countries such as the United States of America, the EU has the same
common goal, which is to make business transactions work more easily
and smoothly. One of the ways to achieve this goal is to use a common
currency as in case of the United States’ dollar. It would not be easy to do
business if people from New York had to exchange money to do business
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in New Jersey, and vice versa. When it comes to the EU, the theory of
making business and money transactions easier is accomplished with
the euro. The euro was launched as an electronic currency and
accounting unit in January 1999, and has been in circulation as a
currency since January 1, 2002 in Austria, Belgium, Finland, France,
Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain.
Other countries have since joined the Euro Zone including Greece,
Slovakia, Slovenia, Malta, and Cyprus. So the total number is 16 of the
27 member states of the EU (Feenstra and Taylor, 2008).
The ECB and the Euro Zone in theory and practice have
worked well so far. The ECB notes the benefits and advantages of the
euro, “with the establishment of Economic and Monetary Union, the EU
has made an important step toward completing the internal market.
Consumers and firms can now easily compare prices and find the most
competitive suppliers in the euro area, plus EMU is providing an
environment of economic and monetary stability all over Europe” which
stabilizes economic growth and the job market (ECB, 2006).
Traveling and tourism in the Euro Zone is another advantage of
having the same currency. People can compare prices for goods and
services in a foreign country, from their home country. Moreover with
the introduction of the euro, foreign exchange transaction costs and risk
were eliminated within the Euro Zone. The word integration is used a
lot in the European Union theory, because connecting all European
countries and treating them as a whole is the point of the venture. What
currency integration accomplishes, according to the ECB, in financial
markets is the following:
• The euro area’s interbank money market is fully integrated.
• The euro- denominated bond market is well integrated, deep
and liquid, and provides a wide choice of investments and
funding.
• The euro area equity market is increasingly viewed as single
market.
• Domestic and cross-border mergers and acquisitions have
increased among banks in the euro area
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All of these integration factors will positively affect economic
growth and will create more jobs (ECB, 2006).
Countries have to fulfill certain criteria that are set by the
Maastricht Treaty, as noted previously. The Maastricht Treaty laid out
four criteria that countries must meet to become eligible to join the Euro
Zone. First, a country’s inflation rate was not to exceed the average
inflation rate of the three best-performing member states by more than
1.5 percent. Second, long term interest rates were not to exceed by more
than 2 percentage points, the average of the three best-performing
member states. Third, the exchange rate of a country’s currency must
have stayed within the normal margins provided by the exchange rate
mechanism for at least two years, without devaluing against the currency
of any other member state. Fourth, a country’s government-deficit-toGDP ratio must not exceed 3 percent and its ration of government debt to
GDP must not exceed 60 percent (Dominguez, 2006).
Structure of the European Central bank.
The ECB is made up of three decision making bodies. These bodies are
the main one, the Governing Council, the Executive Board, and the
General Council also called general committee. The main role of the
Governing Council is to adopt guidelines and make decisions which
ensure the continued performance of the tasks of the Euro-system, and
to formulate monetary policy related to key ECB interest rates and
liquidity. The members of the Governing Council are the six members of
the Executive Board, plus the governors of the national central banks of
the 16 euro area countries (Feenstra and Taylor, 2008).
The Executive Board’s role is to implement of the monetary
policy of the ECB, prepare for meetings of the Governing Council, and
conduct the day-to-day business of the ECB. The board contains the
president (Jean-Claude Trichet) of the ECB , and four members that are
appointed on the basis of professional merit and monetary/ banking
experience, also three or four members of the Executive Board are from
the large countries (Germany, France, Italy, and Spain) (Feenstra and
Taylor, 2008).
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The General Council’s main role is to report on convergence,
contribute to the advisory functions of the ECB, the collection of
statistical data, the reporting activities of the ECB, and the laying down
of the conditions of employment of the staff of the ECB. The members
are the President and Vice-President of the ECB, plus the governors of
the national central banks (NCBs) of the 27 EU Member States. In other
words it includes representatives of the 16 euro area countries and the
11 non-euro area countries. The other members of the ECB’s Executive
Board, the President of the EU Council and a member of the European
Commission may attend the meetings of the General Council, but they
do not have the right to vote (Feenstra and Taylor, 2008). To sum up all
three decisions making bodies, governing council formulates, executive
board implements, and general council applies the monetary policy in
the all Euro Zone states.
Accountability and independence are the two main attributes of
the ECB, because without trust of people in the ECB, the idea of one
central bank for all members of the European Union would not work.
To earn trust from the public and the member states, the ECB set strict
rules for banks regarding of certain functions in the institutions.
Independence is viewed by many economists as a necessary
attribute of any central bank. In the EU, the ECB has sole monetary
policy powers; none are given to any other EU institution. No EU
institution has any formal oversight of the ECB, and the ECB does not
have to report to any political body, elected or otherwise. The ECB does
not release the minutes of its meetings (Feenstra and Taylor, 2008).
ECB independence means that it makes decisions regarding
monetary policy instruments used to achieve its goals. The instruments,
such as setting interest rates, are used with respect to its primary goal of
price stability. In the case of interest rates, the ECB sets “targets” believed
to be consistent with price stability. The often asked question is how the
central bank can stay independent and not to be influenced or pressured
by the member states. It is a multinational institution with difficult tasks
to manage, and one of those tasks is to not to make decisions, or act in
favor of, any member state. They have to make neutral decisions about
monetary policy by looking at the EU as a whole.
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Instruments and Goals of the ECB
The monetary policy used by the ECB is a combination of understanding
the market and what the economy does when the ECB steps in, and
making changes at a certain point of the economic cycle. There is a set
of primary instruments used by the ECB.
The most basic instrument, used by the ECB, is the interest rate
at which EU banks can borrow funds. Since the ECB is highly
independent, the bank must follow certain rules that will prevent the
use of monetary policy to achieve other goals; the ECB may not directly
finance member states’ fiscal deficits or provide bailouts to member
governments or national public bodies. In addition, the ECB is not
required to act as a lender of last resort by extending credit to financial
institutions in the Euro Zone in the event of banking crisis although it
has the option to do that (Feenstra and Taylor, 2008).
Each member economy is constantly changing, because
underlying economic conditions in each country- like buyer’s
preferences, income, price level, political situation and the exchangecurrency markets- fluctuate. Recognizing this, the ECB uses its tools to
create stability in the union as a whole.
The main tool for affecting instruments like interest rates, are
open market operations. Open market operations include “temporary
lending of money for collateral securities (reverse operations or
repurchase operations, otherwise known as the ‘repo’ market). These
operations are carried out on a regular basis, where fixed maturity loans
for every month are auctioned off” (Kaplan, 2002). Also included in open
market operations are buying or selling securities (direct operations) and
foreign exchange operations such as for-ex swaps, which consist of two
legs- a spot and a forward exchange transaction- which are executed at
the same time for the same quantity and therefore offset each other. “All
of these interventions can also influence the foreign exchange market
and thus the exchange rate” (Kaplan, 2002).
The same kinds of interventions are used by other central
banks around the world. For example, the People’s Bank of China and
the Bank of Japan have on occasion bought several hundred billions of
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U.S. Treasuries, presumably in order to stop the decline of the U.S.
dollar versus the renminbi and the yen. The same transactions are
constantly happening with the euro.
Open market operations may be used for two basic situations;
expansionary policy is used for a sluggish economy and contractionary
policy is used when inflation threatens. The first scenario is when the
European economy is slow and needs a jump start to increase financial
and economic activity. In this case the ECB needs to step in and apply
its expansionary policy, which include raising money supply and
lowering interest rates the goals of which are encouraging investment
and increasing employment.
In order to make these changes to respond the market shocks,
the ECB uses the tools of monetary policy. According to White, the ECB
influences the money supply in the economy directly. Each time it buys
securities, exchanging money for the securities, it raises the money
supply. Conversely, selling of securities lowers the money supply (1999).
Open market operations are the primary tool of a central bank. Other
tools include:
1. Adjusting the interest rate on the main refinancing
operations (MRO), which provide the bulk of liquidity to the
banking system,
2. Adjusting the interest rate on deposit facilities, which banks
may use to make overnight deposits with the Euro system,
3. Adjusting the rate on the marginal lending facilities, which
offers overnight credit to banks in the Euro system, and
4. Altering the reserve requirements (the percentage of
deposits required held) for credit institutions (European
Central Bank, 2009).
The impact of manipulating these tools may be seen in
the following figure. In Figure 1, manipulation of interest rates has
the theoretic impact of increasing economic activity economy wide.
Enhancing money supply should help push down interest rates with
the following results.
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Figure 1: The Impact of Decreasing Interest Rates
Price Level (P)
Figure 11-7 Decreases in the Interest Rate
Increases Aggregate Demand
AS2
P2
AD1
Y1
Y2
AD2
YF Output (Y)
Source: Feenstra and Taylor, 2008
The second scenario for the ECB occurs when the economy is
too “hot.” The ECB is able to use the contractionary monetary policy to
slow the economy down; here the money supply is reduced, interest
rates should go up, in turn causing investment to go down, and GDP
will go down as well. In order to do this, the ECB applies the same
monetary policy tools listed above, though in contractionary policy,
open market operations involve the sale of securities and raising of
rates. The impact on the money market of contractionary policy can be
seen in Figure 2, following.
Figure 2: A Contraction in the Money Market
Nominal
Interest
Rate
Source: Feenstra and Taylor, 2008
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quantity
of
money
The main goals of the ECB are to maintain price stability in the
European area and smooth out transactions in financial markets.
Specifically, “the primary objective of the ECB’s monetary policy is to
maintain price stability. The ECB aims at inflation rates of below, but
close to, 2 percent over the medium term” (European Central Bank,
2009). Some economists believe that the ECB’s decision to define price
stability so specifically might not give them much room when they
formulate their decisions. Having a certain target could bring pressure
on the ECB from forces outside the EU, and focus on just the inflation
rate may draw the ECB’s attention away from other important economic
issues like Gross Domestic Product performance, economic growth,
and unemployment.
A lack of focus on these other issues may have a particularly
negative impact on some member states. These economists, as well as
other policy makers and members of the public, argue that the ECB is
too “independent” compared to the U.S. Federal Reserve (the FED), the
U.S. central bank, which is obligated to ensure price stability and
achieve full employment. Moreover, the FED does not state an exact
inflation target which puts less pressure on their decision making
regarding the amount of credit in the financial system and the interest
rates. Central bank independence is a topic of ongoing economic and
political discussion. In light of the U.S. FED’s response to the recent
economic crisis, the U.S. Congress has raised questions about FED
independence.
Research into central bank independence suggests that
countries with greater central bank independence have experienced
lower inflation rates (White, 1999). The opposing argument is that a
central bank which is able to resist political demands is also able to
resist public accountability for choosing the wrong goals, choosing the
wrong techniques to attain those goals, and using the techniques
incompetently (White, 1999). The inflation experience of the EU is
detailed in Figure 3, following.
It is noted by Dominguez that, while the primary objective of
the ECB is stated as price stability, economic growth is mentioned as a
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secondary objective. Specifically, Article 105 of the Maastricht Treaty
defines that “the primary objective of the ECB shall be to maintain price
stability” and that “without prejudice to the objective of price stability,
the ECB shall support the general economic policies in the community”
(2006). The contrast with the FED’s objectives seemingly is one of
degree, rather than a complete distinction.
Figure 3: Harmonized Index of Consumer Prices (HICP)
HICP target
Average inflation since 1999
5
5
Start of Stage Three of BMU
4
4
3
3
2
2
1
1
1995
2000
2005
2010
Source: Eurostat, The European Central Bank.
Interest Rate Targets of the ECB
Besides controlling the money supply in the euro financial system, the
ECB deals with three main interest rates; they are the marginal lending
facility rate (discount window) which is the rate that the ECB offers
overnight credit to banks in the euro system, the main refinancing rate
which is the publicly visible interest rate that the central bank
announces. This is also known as minimum bid rate and serves as a
bidding floor for refinancing loans. The deposit rate is the rate parties
receive for deposits at the central bank.
In addition to its own interest rates, the ECB focuses on the
Euribor, which is the interbank interest rate. It is a rate at which EU
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banks lend money to one another within the Euro Zone- commercial
banks in the Euro Zone set this rate (The European Central Bank, n.d.).
Combining these rates together in Figure 4 illustrates how they relate to
each other. When there is confidence within credit institutions, the
Euribor is usually low; this is because credit institutions lend money to
each other when there is an environment of confidence, giving loans
and boosting investment, thus keeping liquidity in the market.
Conversely, when the rate is too high it indicates the opposite of high
confidence. This is the time when the ECB steps and uses one of its
monetary tools.
Figure 4: Various Interest Rates in the EU
European Central Bank interest rates and money market rates
Marginal lending rate, Eurosystem
Overnght deposit rate, Eurosystem
Eurosystem: minimum bid rate in the main refinancing operations
1-month Euribor
Eonia
6.0
5.0
%
4.0
3.0
2.0
1.0
0.0
2003
2004
2005
2006
2007
Sources: European Central Bank and Reuters.
Copyright Suomen Pankki - Finlands Bank
2008
15.1.2008 - 221 - PT
Source: The European Central Bank, n.d.
Currently, the ECB is trying to respond to economic shocks. In
April 2009, ECB lowered the main refinancing rate to 1.25 percent, the
lowest ever at that point; by May 2009 this rate was lowered and
remains at one percent. On July 2008 the marginal lending facility rate
was 4.25 percent; by May 2009 this rate was down to 1.75 percent, down
from the highest borrowing rate from October 2000 to May 2001 at 4.75
percent. In fall of 2008, the deposit rate was 3.75 percent; it was down to
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.25 percent by May 2009. This expansionary interest rate policy reflects
the world wide recession (The European Central Bank, n.d.).
Required Reserve Requirements: The Last Tool
The last tool of monetary policy is changing the minimum reserve
requirement “The reserve requirement is a bank regulation that sets the
minimum reserves each bank must hold to customer deposits and
notes” (Mishkin, 2006). The reserve ratio is sometimes used as a tool in
the monetary policy, influencing the country’s economy, borrowing, and
interest rates. The People’s Bank of China does use changes in reserve
requirements as an inflation-fighting tool and raised the reserve
requirements nine times in 2007. According to the ECB,
Minimum reserves are an integral part of the operational framework
for the monetary policy in the euro area. The intent of the minimum
reserve system is to pursue the aims of stabilising money market
interest rates, creating (or enlarging) a structural liquidity shortage and
possibly contributing to the control of monetary expansion. The reserve
requirement of each institution is determined in relation to elements of
its balance sheet. In order to pursue the aim of stabilising interest rates,
the Eurosystem’s minimum reserve system enables institutions to make
use of averaging provisions. This implies that compliance with the
reserve requirement is determined on the basis of the institutions’
average daily reserve holdings over a maintenance period of about one
month. The reserve maintenance periods start on the settlement day of
the main refinancing operation (MRO) following the Governing Council
meeting at which the monthly assessment of the monetary policy
stance is pre-scheduled. The required reserve holdings are
remunerated at a level corresponding to the average interest rate over
the maintenance period of the main refinancing operations of the Euro
system. (European Central Bank, n.d.).
For the Euro area, the ECB sets two basic reserve requirements.
The first reserve requirement is two percent, set on overnight deposits,
deposits with agreed maturity or period of notice up to two years, debt
securities issued with maturity up to two years, and money market
paper. The second reserve requirement, currently zero percent, is on
deposits with agreed maturities, or periods of notice over two years,
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repos, debt securities issued with maturity over two years. A reduction
in reserve requirements is also an expansionary monetary policy.
The ECB has the power to make certain exceptions when it
comes to reserve requirements. Institutions that want to have this option
must request and fulfill certain conditions; “the institution has a special
function that would make the imposition of a minimum reserve
requirement run counter to the purpose of the system; and the
institution is subject to re-organizational measures. The ECB may also
exempt credit institutions from fulfillment of the euro system’s
minimum reserve requirements (without the need for a request to be
submitted via the correspondent central bank) in the reserve
maintenance period in which the institutions will cease to exist:
because its banking license is being withdrawn or surrendered, or
because it is subject to winding-up proceedings” (The European
Central Bank, n.d.).
Conclusion
In conclusion, being a central bank in a single country is not an easy
task, being a central bank in a union of 27 countries, 16 of which share
a common currency, is an extremely difficult task. The ECB has played
a major role in the European financial system and in many member
countries as well. The three main goals of monetary union, free trade,
one central bank, and one currency are already achieved in 16 out of 27
EU countries.
The three branch structure of the ECB makes the central bank
powerful and its management complex; it has total independence from
any of the governments in the EU, but it also must find some degree of
consensus on basic policy decisions between large numbers of member
state representatives. Such consensus is required for the design and
implementation of monetary policy that will be applied to a large
number of very different economies.
The Bank’s ability to use the basic monetary tools such as
controlling money supply, setting interest rates, and reserve
requirements would be difficult under any circumstances; when such
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decisions impact all member states, each with its own economic
conditions and issues, using such tools become particularly difficult. In
spite of the fact that the ECB is a relatively young institution and the EU
itself is evolving, most economists think that the ECB has managed its
role as a central bank well throughout its brief existence.
References
Dominguez, K. M. E. (2006, October). The European central bank, the euro, and
global financial markets, Vol. 20, No. 4.
Retrieved April 12, 2009, from JSTOR database.
The European Central Bank. Home page.
http://www.ecb.int/home/html/index.en.html.
Feenstra, E.R., and Taylor, M.A. (2008). International macroeconomics.
New York, NY: Worth Publishers.
Kaplan J. (2002). The Federal Reserve and monetary policy.
Retrieved April 5, 2009, from
http://images.google.com/imgres?imgurl=http://www.colorado.edu/Economics/
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Mishkin S. F. (2006). The economics of money, banking, and financial markets.
New York: Prentice Hall.
Moutot P., Jung A.,and Mongelli F. P. (2008). The workings of the eurosystem,
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