In addition, the Eurosystem also acted as an investor-of-last-resort in stressed markets, for example when it purchased government bonds in illiquid secondary markets within its Securities Markets Programme (SMP) between 2010 and 2012. This prompts the questions: Can central bank liquidity provision or asset purchases during a financial crisis reduce risk in net terms? This could happen if risk taking in one part of the balance sheet (e.g., more asset purchases) de-risks other balance sheet positions (e.g., the collateralized lending portfolio) by an equal or even larger amount. How economically important can such risk spillovers be across policy operations? And were the Eurosystem's financial buffers at all times sufficiently high to match its portfolio tail risks? The authors address these questions by studying monetary policy exposures taken from the Eurosystem's weekly consolidated balance sheet between 2009 and 2015.
Two main findings stand out:
1. Lender versus investor of last resort implied credit risks are usually negatively related in the sample. Taking risk in one part of the central bank's balance sheet (e.g., the announcement of asset purchases within the SMP) tended to de-risk other positions (e.g., collateralized lending from previous LTROs). Vice versa, the allotment of two large-scale VLTRO credit operations each decreased the one-year-ahead expected shortfall of the SMP asset portfolio. This implies that in bad times, increasing the ECB's balance sheet size increases risk less than proportionally. Conversely, reducing balance sheet size may not reduce total risk by as much as one would expect by linear scaling. Arguably, the documented risk spillovers call for a measured approach towards reducing balance sheet size after a financial crisis.
2. Some unconventional policy operations did not add risk to the Eurosystem's balance sheet in net terms. For example, the authors find that the initial OMT announcement de-risked the Eurosystem's balance sheet by 41.4bn euro in 99% expected shortfall (ES). They conclude that, in extreme situations, a central bank can de-risk its balance sheet by doing more, in line with Bagehot's well-known assertion that occasionally ``only the brave plan is the safe plan." Such risk reductions are not guaranteed, however, and counterexamples exist when risk reductions did not occur.
Caballero, Diego, Lucas, André, Schwaab, Bernd, Zhang, Xin (2019). Risk endogeneity at the lender/investor-of-last-resort. ECB Working paper No. 2225..