5 steps ECB has taken to combat Europe's debt crisis

NDTV Profit Desk

07 Sep 2012, 01:59 PM IST

Outright Monetary Transactions: On Thursday, Mario Draghi, the president of the European Central Bank, unveiled a package of measures that is designed to ease the strains in Europe's debt crisis and secure the future of the euro currency. He announced that the central bank was creating a new bond-buying program, called Outright Monetary Transactions. The so-called OMT, which will replace the previous program, will see the ECB buying short-term bonds of between one and three years and will have no limits. Countries that have their bonds bought will have to accept certain conditions, which will be part-monitored by the International Monetary Fund. The bond purchases will not increase the money supply in the 17-country Eurozone.
Tough talk: ECB president Mario Draghi warned in July that the bank would do "whatever it takes" to preserve the euro and added, "believe me, it will be enough." The bank's governing council agreed Aug. 2 that it would come up with a plan to purchase the bonds of indebted countries and lower their borrowing costs — if they first ask for help from the Eurozone bailout fund. Draghi's reassurance that the bank was ready to take action has calmed markets for government bonds. This has already helped lower borrowing costs in bond markets, at least temporarily, for Spain and Italy. High borrowing costs could push those countries into a financial collapse that could break apart the shared European currency.

Bond purchases would drive bond prices up and interest yields down in the open market. Governments could then take advantage of those lower yields when they sell bonds to pay off old bonds that are coming due.
Cheap loans: The ECB made an unlimited amount of cheap, three-year loans available to banks on two occasions since late last year. In December, 523 banks borrowed €489 billion ($608.17 billion) and in February 800 banks borrowed €530 billion. The more than €1 trillion action helped to relieve stress on banks, especially those that were having difficulty borrowing from other banks.

The long duration of the loans gave banks security that they would have the money they needed until 2015. Another key feature was looser collateral requirements that let banks post different types of securities in return for loans. That gave them more chances to obtain money — but increased the ECB's risk of losses as it takes on shakier securities.

The loans provided indirect relief to heavily indebted countries that were facing high borrowing costs in bond markets. Some banks took the cheap money and started buying higher-yielding government bonds with it. That raised bond prices and lowered bond interest rates, which equates to lower borrowing costs for struggling countries, such as Spain and Italy.
Lower interest rates: The ECB has cut its key interest rate by a quarter percentage point three times since November. The so-called main refinancing rate is now at a record low of 0.75 percent. That is what the bank charges on credit it offers to Eurozone banks. The rate strongly influences interest rates on the loans banks provide to each other, businesses and consumers.

The ECB has lowered the rate it pays banks for depositing their money with the ECB overnight to zero. That increases the incentive for banks to lend money to each other or to businesses rather than park it with the ECB.
Reserve cut: In December, the ECB cut the amount that banks must keep on reserve with it, from 2 percent of their assets to 1 percent. That freed some €100 billion for the banks to use elsewhere.

Beginning in May 2010, the bank intermittently bought over €200 billion in government bonds of financially weak countries like Spain and Italy on the secondary market — meaning from other investors. The goal was to lower the bond yields, making it cheaper for governments to borrow.

The program temporarily held yields down, helping calm the debt crisis for a while. But the program had only limited impact. The ECB was unwilling to buy bonds on a larger scale, a step some said would violate the bank's prohibition on financing governments. The program has been shelved and the ECB is coming up with plans for what it says will be a more robust intervention, "of a size adequate to achieve its objectives."

The ECB is prohibited from buying bonds directly from governments.