Thursday, December 16, 2010

ECB Raises Capital or Why the ECB cannot Delever (fg)

In its today's meeting, the Governing Council of the ECB decided to increase its capital from €5.76 billion to € 10.76 billion. The press release contains the following statement:
The capital increase was deemed appropriate in view of increased volatility in foreign exchange rates, interest rates and gold prices as well as credit risk. As the maximum size of the ECB’s provisions and reserves is equal to the level of its paid-up capital, this decision will allow the Governing Council to augment the provision by an amount equivalent to the capital increase, starting with the allocation of part of this year’s profits. From a longer-term perspective, the increase in capital – the first general one in 12 years – is also motivated by the need to provide an adequate capital base in a financial system that has grown considerably
Such a move is typically an appropriate alternative by banks which are imposed to capital constraints and whose constraints are binding. A bank can either sell assets or it can raise new capital in times of binding constraints. In general, the `debt overhang' problem makes a bank reluctant to raise new capital because new capital would be immediately siphoned off by the more senior creditors. Therefore, in the shareholders' interest, a bank usually let the asset side shrink by following a de-leveraging strategy. By taking on the central bank perspective, the ECB is not able to sell assets because such portfolio re-shuffling would impose additional impetus on financial market volatility. The balance-sheet management of the ECB during the last two years had exactely the aim of buying low credit-rated security instruments in order to prevent yields from exploding. The bad bank, on an insitutional level, was born. Apparently, in these days, the ECB's capital contraint binds due to capital losses generated by write-downs. National governments, thus, are forced to transfer capital to the ECB's balance sheet. The decision enables the ECB to be capable of acting with its unconventional policy instruments.