A Model of the open Market Operations of the European Central Bank

Abstract

We model the two types of tenders used by the European Central Bank in its open market operations. We assume that the ECB minimises a loss function that depends on the difference between the interbank rate and a target rate that characterises the stance of monetary policy. When the loss function penalises interbank rates below the target more heavily, fixed rate tenders have a unique equilibrium with high overbidding, while variable rate tenders have multiple equilibria with moderate overbidding. Our empirical analysis is consistent with the predictions of the model and supports the hypothesis of an asymmetric loss function. The monetary policy instruments chosen by the European Central Bank (ECB)' in order to implement its monetary policy are minimum reserves, open market operations and standing facilities. The minimum reserves help to ensure that the euro area banking system has an aggregate liquidity deficit which is covered by two main types of open market operations: the main refinancing operations and the longer-term refinancing operations. The former (latter) are liquidity providing collateralised transactions with a weekly (monthly) frequency and a maturity of two weeks (three months).2 The banks can also obtain or place overnight liquidity at the marginal lending and deposit standing facilities. The refinancing operations can be conducted via either fixed rate or variable rate tenders. In fixed rate tenders the ECB announces an interest rate and the banks bid the amount of reserves they want to borrow at this rate. If the aggregate amount bid exceeds the liquidity that the ECB wants to provide, each bank receives a pro-rata share of this liquidity. In variable rate tenders the banks bid the amounts they want to borrow and the interest rates they are willing to pay. In this case, bids with successively lower interest rates are accepted until the total liquidity to be allotted is exhausted.