In response to the financial crisis, the Earosystem has introduced a number of non-standard monetary policy measures. The aim of these measures has been to sustain financial intermediation in the euro area, foster the flow of credit to enterprises and households, and support the monetary policy transmission mechanism. As a consequence, the composition of the Eurosystem's balance sheet has changed: its balance sheet total has increased while the risks assumed by the Eurosystem have risen substantially. Looking ahead, this development will entail new challenges for the Eurosystem's monetary policy.
A LEAN CENTRAL BANK BALANCE SHEET
Extraordinary times call for extraordinary measures. Unfortunately, a larger balance sheet generally also bears greater financial risks. This is why--under normal economic conditions--central banks aim for lean balance sheets.
What exactly is a "lean balance sheet"? The liability side of a central bank balance sheet reflects the banking system's structural need for central bank money. Banks need this money in order to cover their clients' cash requirements, make payments on the interbank market, and, in some cases, fulfill a minimum reserve requirement. A central bank's balance sheet can thus be regarded as lean if banknotes in circulation make up the majority of the balance sheet total, provided that the minimum reserve requirement is correspondingly low. Even including equity and provisions ought not to lead to a significantly higher balance sheet total. Liquidity is provided via monetary policy operations. These constitute the domestic assets of a lean central bank balance sheet, whereas foreign assets are primarily reserve assets.
A lean balance sheet also boosts a central bank's financial strength as banknotes in circulation are a non-interest bearing liability. Banknotes in circulation form the basis for what is known as seigniorage: a central bank's net income from its monopoly of issuing base money. Although profit maximization is not one of the alms of a central bank, a positive income increases its reputation and ultimately also its financial independence. However, central banks' balance sheets are often less than lean as they may have taken on many past and current additional tasks.
EUROSYSTEM'S BALANCE SHEET BEFORE THE CRISIS
The Eurosystem's consolidated financial statement contains the Eurosystem's assets and liabilities on the balance sheets of the seventeen euro area national central banks and of the European Central Bank. The statement also contains some relics from the past: prior to the launch of monetary union, many national central banks managed exchange rates and accumulated foreign reserve assets whose value far exceeded the volume of banknotes in circulation. Some of these assets remained on central banks' balance sheets after their countries had acceded to European monetary union.
Taking the share of banknotes in circulation in the balance sheet total as an indicator of how lean a central bank's balance sheet is, there were marked differences between the Eurosystem, the U.S. Federal Reserve, and the Bank of England prior to the crisis. Banknotes in circulation comprised around 90 percent of the Fed's balance sheet total, whereas they made up only around half of the balance sheet total for the Eurosystem and the Bank of England. It should be borne in mind that the Eurosystem--in accordance with its statute--has sole responsibility for managing all foreign reserve assets, whereas this task is carded out jointly by the Treasury and the central bank in both the United Kingdom and the United States. This illustrates how a broader area of responsibility can lead to less-streamlined balance sheets. Furthermore, accounting principles differ, especially with regards to the valuation of gold, which for example contributes to a shorter balance sheet for the Federal Reserve System. However, as a consequence of the anti-crisis measures, the balance sheet total of all three central banks rose significantly. The increase in a central bank's balance sheet total due to crisis-induced measures will be comparatively greater if its balance sheet--like the Fed's--was relatively lean to start with.
DURING THE CRISIS
Exactly how did the crisis-related non-standard monetary policy measures affect the Eurosystem's balance sheet? When the financial market turmoil began in mid-2007, tensions were mainly caused by the lack of trust among the participants on the interbank money market. This was because of uncertainty about counterparties' financial soundness and liquidity. The Eurosystem responded to the reduced interbank activity on the money market by introducing longer maturities for its liquidity-providing monetary policy operations, although overall liquidity from monetary policy operations remained unchanged on average. During the period of extreme uncertainty, heightened mistrust, and increased financing bottlenecks following the Lehman Brothers insolvency, banks made increasing use of the Eurosystem's extended provision of liquidity at rapidly falling key interest rates. Besides introducing feted-rate tender procedures with full allotment in all monetary policy refinancing operations, the Eurosystem extended its monetary policy collateral framework, for example, by lowering the minimum credit rating threshold while at the same time...