OMT ain’t no LOLR

It’s quite funny to see, how many people seem not to grasp what the ECB’s Outright Monetary Transactions (OMT) really are. Quite a number of people out there confuse this with a central bank’s task to act as a lender of last resort (LOLR).
The difference is simple – in fact so simple, I would never have thought that there could be any confusion about LOLR at all.

To understand the concepts, let me briefly repeat what exactly a central bank is. Well, the name says it all, it is the bank in the centre of an economy’s banking system, the bank of the banks, if you will. As such it provides liquidity and banking services (such as accounts) to commercial banks. Usually in our times, the central bank also issues the legal tender – Euros, Dollars, Swissfranks, whatever. The issuance of tender is however not neccessarily a job for the central bank – it could also be issued by the finance ministry or treasury.
As such, the central bank ensures that banks with liquidity shortage can borrow from her at any time – usually at a punitive rate, the so called marginal refinancing rate. Furthermore, the central bank acts as a sink for excess liquidity, that banks do not want to lend to other banks – again usually at a punitive rate, the deposit rate.

In normal times, that is when there is a liquid and functioning interbank financing market, these functions of the central bank are not needed. When there is enough trust, that the counterparty will still be there tomorrow, then banks will lend to other banks at rates above the deposit rate and below the marginal rate. The liquidity finds its own way, without the need to be channeled trough the central bank.

In the summer of 2008, following the collapse of Bear Stearns and later of Lehman Brothers, there was no functioning, liquid interbank market, since nobody knew if the counterparty would be there tomorrow to repay the overnight loan. Then the central banks of the world stepped in and fulfilled their job as a lender of last resort. It was neccessary, well-planned and flawlessly implemented. LOLR like in your macro textbook. There is absolutely no doubt that a banking system – since it is by design illiquid – needs a liquidity backstop. Usually and rightly, this is the job for a central bank.

And now to something completely different

Now, OMT is something entirely different. It is a liquidity backstop, that much is true. But the liquidity is for the member countries of the Euro. It is precisely the idea behind OMT to decouple a country’s finance from the banks. That is, OMT is meant to be a credible defense for the interest rates countries have to pay for sovereign debt.
OMT does not protect the banks against a failing interbank market – it protects sovereigns against overindebtedness due to soaring interest rates, and by doing so protecting the integrity of the Euro area. But OMT has nothing to do with the interbank market.

There is one channel, where OMT also benefits the banks, this however indirectly. The ECB guarantees the solvency of the Euro area members by committing to do “whatever it takes”. This bailout guarantee takes also a default risk on banks’ holfings of sovereign debt and thus decreasing the risk that a bank will fail due to the default of a Euro area member. Indirectly, OMT protects the interbank market up to a certain point – but OMT alone would not prevent bank failures in the case of a interbank lending dry-up, it only makes such a dry-up less likely. Still, would a situation arise like in the summer of 2008, a proper lender of last resort policy would again be needed besides OMT and the like.

This shows that OMT and LOLR are not only conceptually different but also fulfil different functions. These policies are not equivalent. We can possibly see OMT as a kind of state financier of last resort – but this view is hard to square with the ECB being prohibited to finance countries. Note that we can still argue whether OMT is neccessary or even legal, but that’s a different story. Regardless of your view on OMT, it ain’t no LOLR.

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I write about economics and politics. I take Ordnungspolitik seriously. While not blogging, I study monetary unions for my doctorate.