Central banks have a core mission, which is to control inflation. When times are bad, they can drop interest rates and pump money into the economy so that things will improve. This is the essence of monetary policy, and it is the mechanism by which central banks manage the trade-off between inflation and unemployment.
The theory is straightforward, but the practice is, of course, rather more complex. Recently, researchers have been puzzling over an apparent blockage in the European financial system that is preventing monetary policy from having its full effect. The culprit may be the power of big commercial banks in over-the-counter markets, finds research by the European Central Bank’s Jens Eisenschmidt, Columbia’s Yiming Ma, and Chicago Booth’s Anthony Lee Zhang.
To enact monetary policy, a central bank intervenes in the repo market—an obscure but critically important part of a financial system in which large trading banks make short-term, typically overnight loans to each other on the basis of securities. A central bank trading in the repo market will buy or sell reserves and impose a certain interest rate: price floors and ceilings that aim to control interest rates, not only in the repo market itself, but also in other markets where large trading banks make deals with other institutions.
The idea is that interest-rate cuts enacted by central banks will affect repo markets, and in turn affect other money markets, where the likes of BNP Paribas, Citi, Credit Suisse, Deutsch, or Goldman Sachs trade with commercial institutions, which in turn affects end customers, i.e., businesses, households, and consumers in the real economy.
Research has shown that this monetary-policy pipeline is a bit blocked. The mechanisms that undergird the repo markets are such that trading banks have leeway to shift the needle on interest rates imposed by central banks. They can buy securities and reserves and sell them at higher or lower rates, for instance, before buying them back to make a profit. Booth’s Quentin Vandeweyer, among the people looking at this issue, has argued that, in the United States, regulatory changes made repo-market deals less profitable for big banks, thus clogging up the pipeline through which monetary policy is transmitted. (For more, read “The Fed still has control over interest rates.”)
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Should the ECB Prioritize Jobs and the Environment?But Eisenschmidt, Ma, and Zhang argue that in Europe, these blockages aren’t just a problem in repo trades. When BNP, Deutsche, and others trade with commercial entities—hedge funds, pension funds, and commercial banks—in other money markets, they are able to charge higher interest rates than those imposed by central banks, such that minor blockages can become a fully blown bottleneck.
Leveraging new data released by the European Central Bank, the researchers conducted a large-scale study looking at what’s going on in the European repo market, as well as at whether or not interest-rate cuts at the central-bank level are reaching, and benefiting, end users in the real economy.
“We find that the large European trading banks exert market power in their over-the-counter trades with commercial entities. This inhibits the pass-through of monetary policy in the European repo market. Dealer market power means that the ECB’s rate cuts don’t make it into the real economy fully efficiently,” says Zhang.
“The ECB might drop interest rates to 1 percent, but Deutsche, BNP, and others know that there are mutual funds and others trading with them in different financial markets that are willing to pay 2 percent on a loan or more. So they can go ahead and charge, say, a 1.5 percent interest rate, because it means more profit for them. And the market structures allow for this.”
End customers looking to leverage a cut announced by the ECB may well not end up seeing the benefit when they go to their bank looking for a loan or a mortgage, says Zhang. Banks are still able to charge their customers what they are willing to pay, instead of the real cost imposed by the ECB. And that’s bad news both for the central bank looking to make things better in the economy, and for businesses and individuals hoping to benefit from monetary policy.
This paper is the first to use both trader- and consumer-level data from banks’ trading reports, and to shed light on these inefficiencies in European money market rates. The researchers urge policy makers to take note of the findings and to think about how to attenuate these effects.
One solution, Zhang says, could be to simplify the repo market in Europe to allow access to mutual funds and commercial banks, enabling them to go directly to the ECB— something they are currently unable to do.
“We have experienced similar frictions in the US, and in response, the Fed opened up repo-market access to some nondealer funds and other money market entities to partially circumvent the dealer part of the pass-through process,” says Zhang.
Another option would be to open up more competition in money markets, enabling mutual funds to trade with more dealers instead of just one or two, which is the current norm.
Jens Eisenschmidt, Yiming Ma, and Anthony Zhang, “Monetary Policy Transmission in Segmented Markets,” Working paper, June 2021.
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