THE EUROPEAN CENTRAL BANK'S OPEN MARKET OPERATIONS: FIXED VERSUS VARIABLE RATE TENDERS

Why was there so much overbidding for liquidity by banks in the early days of the European Central Bank's (ECB) open market operations? And why did the ECB then switch from fixed rate tenders to variable rate tenders? New research by Juan Ayuso and Rafael Repullo, published in the October 2003 Economic Journal, provides an explanation.

When Stage Three of Economic and Monetary Union was launched in January 1999, the ECB started to provide the bulk of the liquidity to the financial system through open market operations conducted as fixed rate tenders. Under this arrangement, the ECB announced an interest rate and banks bid the amount they wanted to borrow at that rate. If the demand for liquidity was above the amount the ECB wanted to provide, banks received a pro-rata share of their bids.
A striking feature of these tenders was the increasing degree of overbidding by the banks, which reached a peak in June 2000 when the amount bid exceeded €8,400 billion while the corresponding allotment was only €75 billion.

That very month, the ECB decided to switch the procedure to variable rate tenders with a minimum bid rate. In this type of tender, banks bid the amount they want to borrow and the interest rate they are willing to pay, which has to be above the minimum rate. Bids with successively lower interest rates are then accepted until the total liquidity to be allotted has been exhausted. After the switch, overbidding was drastically reduced.

Against this background, Ayuso and Repullo provide an explanation of why banks behaved this way and use data from a large number of fixed and variable rate tenders to validate it. Their results suggest that a very plausible explanation for the overbidding by banks during the fixed rate tender period and its subsequent reduction after the switch to variable rate tenders was the reluctance of the ECB to see market rates fall below the tender rate. As might be expected of a newly created central bank that wants to gain credibility for its anti-inflationary monetary policy quickly, this reluctance was greater than its unwillingness to see them above the tender rate.

The rationale behind this result is simple:
" The ECB tries to avoid market rates falling too low by restricting the supply of liquidity, and this opens up a differential between the expected interbank rate and the tender rate.
" Under fixed rate tenders, banks try to exploit this spread by demanding excess liquidity at the tender, which they then place on the interbank market to make a profit.
" Under variable rate tenders, however, banks compete away this differential by offering higher rates. Therefore, overbidding is reduced and bid rates tend to be above the minimum rate.
These results do not change when allowance is made for a role for alternative explanations for overbidding like expectations of future interest rate hikes by the ECB.

The analysis also provides an explanation for the explosive growth of bids during the fixed rate tender period (related to banks' learning about the tolerance of overbidding by the ECB). In addition, it is useful for addressing a number of interesting related issues like the difference in the equilibrium outcomes of Dutch and American variable rate tender auctions (there is none), and the advantages of announcing the desired liquidity provision prior to the tender (there is a new equilibrium with zero overbidding). The framework may also be useful for analysing alternative tender procedures like the so-called full allotment fixed rate tender auction.

ENDS

Notes for Editors: 'A Model of the Open Market Operations of the European Central Bank' by Juan Ayuso and Rafael Repullo is published in the October 2003 issue of the Economic Journal.

Ayuso is at the Banco de Espana; Repullo is at CEMFI, Casado del Alisal 5, 28014 Madrid, Spain.

For Further Information: contact RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com); or Professor Repullo on +34-91-429-0551 (email: repullo@cemfi.es).