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The Euro in Crisis Decision Time at the European Central Bank Case Solution

Solution Id Length Case Author Case Publisher
1127 2158 Words (10 Pages) Gunnar Trumbull, Dante Roscini, Diane Choi Harvard Business School : 711049
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The dramatic shift of focus of the financial system from its long-established role initiated the financial crisis 2008-2010. That role is supporting the trade and the real investment of a system of speculation and financial gambling. This system did not manage economic risks and created and assumed financial risks. These risks were the result of arbitrage activities and the induction of asset price changes.

Although financial liberalization and innovation have made the world economies more productive and diversified, these financial institutions also sold loans, which had reduced lenders’ incentives to carry out cautious screening and continuous monitoring of credit risk. So, these institutions produced both the booming and the bust environment.

Following questions are answered in this case study solution

  1. Evaluate the ECB’s response to the financial crisis of 2008-2010. What was their analysis of the problem?

  2. The ECB responded less aggressively than the US Federal Reserve to the crisis. Why? 

  3. We now know that the ECB did not directly purchase Greek sovereign debt in May 2010. Given that fact and the developments that have occurred since then (and which we discussed in class), evaluate the merit of the ECB’s decision not to purchase Greek bonds.

  4. In your opinion, what will be the impact of the EUR1 trillion in loans that the ECB recently provided to European banks?

Case Analysis for The Euro in Crisis Decision Time at the European Central Bank

The crisis started in mid-2007 with the sudden financial turmoil. This turmoil escalated stridently in September 2008, turning the crisis of confidence into a global financial panic. Financial intermediaries sold their assets to restore liquidity and also tightened their lending conditions. This induced the spillover from the financial sector to the real economy and consequently, the crisis that instigated in the developed economies spread to the developing economies (Trichet, 2010).

The ECB's response to the crisis was quick, flexible and decisive but with the late decision to purchase bonds from the troubled financial institutions. It injected 9.8 million Euro, during the early period of crisis, into the market without the penalty rate. This helped to steady the Euro-zone credit market. (Trichet, 2009)

The decisions took by the ECB can be broadly divided into two categories, which are interest rate measures and the non-standard measures. The ECB lowered the crucial interest rate by 325 basis points since October 2008, which was the largest cut ever decided over such a short period in Europe. (Directorate-General for Economic and Financial Affairs, 2009) In addition to reducing interest rates, ECB took non-standard measures related to liquidity management when the crisis piled on, and interbank trading came to a practically closed down. These non-standard measures include regular refinancing operations, an increase in the list of assets to keep as collateral and the introduction of a large number of counterparties in the system to help the ECB in refinancing the financial institutions and the banks e.g. European Investment Bank (EIB). Along with these measures, buying of euro- dominated bonds was also one of the key steps taken by the ECB during the financial crisis of 2008. Though ECB made this decision late, but it still managed to save the Europe from the extreme cracking down of the financial system. (Trichet, 2009)

So conclusively, we can say that the ECB acted positively during the financial crisis and can be considered as a reliable institution of stability and confidence.

The ECB responded less aggressively than the US Federal Reserve to the crisis. Why?

The ECB's response to the crisis was the careful regulation of the financial and economic structures and the institutions of the euro area. The difference in the responses made by the US Federal Reserve and the European Central Bank was due to the difference in the market structure and the financial industry of the two regions (Smith, 2010). Banks are dominating in the European financial system, whereas markets formed the US financial system. (Trichet, 2009)

However, throughout the crisis, both of these banks acted and responded in a similar manner. They both took the interventionist approach to the global financial crisis, but the ECB was more interventionist than the Fed. The ECB also acted earlier than the Fed and accepted a wider range of collateral. This allowed the ECB to make use of its traditional lending tools to help struggling institutions, while the economic conditions in the US system forced the Fed to create new lending facilities (i.e., TAF, TSLF, PDF, etc.) in order to accept mortgage-backed securities as collateral for Fed loans. (Dozark-Frideres, 2010)

Furthermore, it is also believed that the Fed’s actions were slightly delayed due to the Fed’s fears about inflation and the directive of Congress to pursue maximum employment, stable prices, and moderate long-term interest rates. Moreover, the Fed was also hesitant in lowering of interest rate due to the already slowed productive growth in the country, depreciation of the dollar and the increase in the prices. However, this reluctance caused inflation to increase and prices to destabilize. Additionally, moral hazard was also the reason for the Fed delayed response. This was due to reason that if Fed stepped in to save financial firms, who already had many risky investments in their balance sheets, would be encouraged to take even bigger risks in their future investments. Moreover, the Fed acted on its traditional policy of concentrating on controlling just inflation. This can also be the reason behind the delayed Fed's response that the Fed waited and did nothing to prevent housing bubble from bursting. (Dozark-Frideres, 2010)

Conclusively, it can be inferred from above that Fed was not fully prepared to tackle this issue. The additional burden of limited resources, availability of limited options and the continuously deteriorating situation of the economy made Fed take some aggressive approach and nontraditional steps with the invention of new methods of liquidating the troubled financial institutions. On the other hand, ECB was well equipped with the options available to it due to its timely response to many of the problems arising during the financial crisis. This put the ECB in a better position to take flexible and traditional actions to tackle the crisis.

We now know that the ECB did not directly purchase Greek sovereign debt in May 2010. Given that fact and the developments that have occurred since then (and which we discussed in class), evaluate the merit of the ECB’s decision not to purchase Greek bonds.

ECB decided to not to purchase the Greek bonds because it wanted to remain solvent and to restore the confidence on euro. Greek financial and economic situation is extremely unstable and it is highly indebted. So buying of such bonds would cause immense losses for the ECB. It is estimated that the ECB has used around 190 billion euros in purchasing Greek assets by supporting the Greek financial institutions. So now, for Greece to decrease its debt to sustainable levels the country should impose a cut down 50% of its debt, which would cause the ECB to face huge losses on the government bonds it has purchased and on the collateral it is holding from Greek banks.(Belke, n.d.)

The restructuring of Greek economy would destabilize the country’s banks, which would not be able to repay any of the loans which they have received from the ECB. Consequently, the ECB would take over the collateral which the Greek banks have given to the ECB to receive the loans. However, the value of this collateral would also fall significantly due to the restructuring of the economy. This means the ECB would not fully recover the loans it has supplied to the banks, and would only be left with the outstanding value of the collateral.

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