The Secret Tool Draghi Uses to Run Europe

Everyone knows central banks are powerful. When I used to visit Alan Greenspan’s office back when I worked for the Fed, he had a sign that said “The buck starts here.” As powerful tools go, there’s nothing that quite beats the power to print money.

So it goes without saying that ECB President Mario Draghi is powerful.  He decides how much money is printed in Europe and what the cost of borrowing that money will be.  But dig deeper and you’ll find that the ECB exerts far more control over events in Europe than the Fed does in the US.

For example, the ECB played a key role in the downfall of Italian Prime Minister Silvio Berlusconi. Since 2010, the ECB has had a program in which it can buy government bonds to help lower a country’s cost of funding.  When Italy’s bond yields rose to dangerously high levels in August 2011, the ECB intervened to buy Italian bonds but also sent a letter to Berlusconi demanding budget cuts and far-reaching reforms.  When Berlusconi failed to act with sufficient haste, the ECB eased off on its bond purchases, yields rose again to dangerously high levels and Berlusconi was forced to quit.

More obscure than the bond-buying program but far more powerful is the little-known “risk control framework”.  Normally, the ECB is willing to provide loans to banks as long as they can pledge assets that are listed on its “eligible collateral list”.   However, the risk control framework allows the ECB to deny credit to any bank or reject any assets as collateral should it see fit.  Specifically:

the Eurosystem may suspend or exclude counterparties’ access to monetary policy instruments on the grounds of prudence


the Eurosystem may also reject assets, limit the use of assets or apply supplementary haircuts to assets submitted as collateral in Eurosystem credit operations by specific counterparties.

The ECB has used the risk-control framework to control events at a number of key junctures in the euro crisis.

Ireland:  In late 2010, the Irish banks were under severe stress.  With international depositors pulling their money out, the banks became heavily dependent on the ECB for funding.  The Irish government has sufficient cash on hand to finance the country for about nine more months and was not seeking funds from the EU or IMF.  The ECB, however, was unhappy with the banking situation and decided Ireland should apply for program funds to sort out the banks.  So, after clearing their throats by revising the risk control framework with Ireland in mind, the framework was put to devastating use.  Faced with ECB threats to withdraw funding and thus trigger a full-scale banking meltdown, Ireland quickly agreed to enter an EU-IMF program.

Spain: By late May of this year, it had become clear to all that Spain’s banks needed substantial recapitalization, starting with Bankia, a recently-created conglomerate of a number of cajas.  The Spanish government decided that its preferred method for recapitalizing Bankia was to directly provide it with Spanish government bonds.  This approach is perfectly legal and would have been approved by Spain’s banking regulators.  However, the ECB didn’t like this approach and effectively vetoed it.   What gave it such a power of veto? The risk control framework.  ECB could simply threaten to refuse credit to Bankia thus triggering the type of crisis the recapitalization plans were attempting to avoid.  Since Spain could not raise the sums involved, this decision effectively forced Spain to apply to the EU for aid with recapitalising its banks.

Leveraging the EFSF\ESM: Perhaps the most powerful suggestion for easing the sovereign debt crisis has been Daniel Gros and Thomas Meyer’s proposal to provide Europe’s bailout funds with a banking licence, thus allowing them to borrow from the ECB.  This ESM bank could potentially purchase trillions of euros worth of government bonds and its existence would provide Italy and Spain with the kind of “bond buyer of last resort” that the Fed has provided for the US government and the Bank of England has provided for the UK government.

However, this plan currently stands little chance of getting off the ground because the ECB opposes it.  Now you might argue that the EU can go ahead and give its bailout funds a banking licence anyway and indeed they could do just that. But, by now, you know the tool that Mister Draghi can use to undermine this plan: The risk control framework. The ECB can simply refuse to accept the ESM bank as an “eligible counterparty”.

All told, the story of ECB’s serial use of its risk control framework raises pretty serious questions about whether it is has been a good idea for Europe to provide this much power to a single unaccountable institution.