Chapter 1 - Overview of the Monetary Policy Framework

1.1 The European System of Central Banks

The European System of Central Banks (ESCB) consists of the European Central Bank (ECB) and the national central banks of the EU Member States². The activities of the ESCB are carried out in accordance with the Treaty on European Union and the ESCB/ECB Statute. The ESCB is governed by the decision-making bodies of the ECB. In this respect, the Governing Council of the ECB is responsible for the formulation of monetary policy, while the Executive Board is empowered to implement monetary policy according to the decisions and guidelines laid down by the Governing Council. To the extent deemed possible and appropriate and with a view to ensuring operational efficiency, the ECB shall have recourse to the national central banks³ to carry out the operations which form part of the tasks of the ESCB. The ESCB monetary policy operations are executed on uniform terms and conditions in all Member States⁴.

1.2 Objectives of the ESCB

The primary objective of the ESCB, as defined in Article 105 of the Treaty, is to maintain price stability. Without prejudice to the primary objective of price stability, the ESCB has to support the general economic policies in the European Community. In pursuing its objectives, the ESCB has to act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources.

1.3 ESCB Monetary Policy Instruments

In order to achieve its objectives, the ESCB has at its disposal a set of monetary policy instruments; the ESCB conducts open market operations, offers standing facilities and may require credit institutions⁵ to hold minimum reserves on accounts with the ESCB.

1.3.1 Open Market Operations

Open market operations play an important role in the monetary policy of the ESCB for the purposes of steering interest rates, managing the liquidity situation in the market and signalling the stance of monetary policy. The ESCB has available five types of instruments for the conduct of open market operations. The most important instrument is reverse transactions (applicable on the basis of repurchase agreements or collateralised loans). The ESCB may also use outright transactions, the issuance of debt certificates, foreign exchange swaps and the collection of fixed-term deposits. Open market operations are initiated by the ECB, which also decides on the instrument to be used and the terms and conditions for their execution. They can be executed on the basis of standard tenders, quick tenders or bilateral procedures⁶. With regard to their aim, regularity and procedures, the ESCB open market operations can be divided into the following four categories (see also Table 1):

• The main refinancing operations are regular liquidity-providing reverse transactions with a weekly frequency and a maturity of two weeks. These operations are executed by the national central banks on the basis of standard tenders. The main refinancing operations play a pivotal role in pursuing the purposes of ESCB open market operations and provide the bulk of refinancing to the financial sector.
• The longer-term refinancing operations are liquidity-providing reverse transactions with a monthly frequency and a maturity of three months. These operations aim to provide counterparties with additional longer-term refinancing and are executed by national central banks on the basis of standard tenders. In these operations, the ESCB does not, as a rule, intend to send signals to the market and therefore normally acts as a rate taker.
• Fine-tuning operations are executed on an ad hoc basis with the aim of managing the liquidity situation in the market and of steering interest rates, in particular in order to smooth effects on interest rates caused by unexpected liquidity fluctuations. Fine-tuning operations are primarily executed as reverse transactions but can also take the form of outright transactions, foreign exchange swaps and the collection of fixed-term deposits. The instruments and procedures applied in the conduct of fine-tuning operations are adapted to the types of transactions and the specific objectives pursued in the operations. Fine-tuning operations are normally executed by the national central banks through quick tenders or bilateral procedures. The Governing Council of the ECB will decide whether, under exceptional circumstances, fine-tuning bilateral operations may be executed by the ECB itself.
• In addition, the ESCB may carry out structural operations through the issuance of debt certificates, reverse transactions and outright transactions. These operations are executed whenever the ECB wishes to adjust the structural position of the ESCB vis-à-vis the financial sector (on a regular or non-regular basis). Structural operations in the form of reverse transactions and the issuance of debt instruments are carried out by the national central banks through standard tenders. Structural operations in the form of outright transactions are executed through bilateral procedures.

1.3.2 Standing Facilities

Standing facilities aim to provide and absorb overnight liquidity, signal the general stance of monetary policy and bound overnight market interest rates. Two standing facilities are available to eligible counterparties on their own initiative subject to their fulfilment of certain operational access conditions (see also Table 1):

• Counterparties can use the marginal lending facility to obtain overnight liquidity from the national central banks against eligible assets. Under normal circumstances, there are no credit limits or other restrictions on counterparties' access to the facility apart from the requirement to present sufficient underlying assets. The interest rate on the marginal lending facility normally provides a ceiling for the overnight market interest rate.
• Counterparties can use the deposit facility to make overnight deposits with the national central banks. Under normal circumstances, there are no deposit limits or other restrictions to counterparties' access to the facility. The interest rate on the deposit facility normally provides a floor for the overnight market interest rate.

The standing facilities are administered in a decentralised manner by the national central banks.

1.3.3 Minimum Reserves⁷

The ESCB's minimum reserves system applies to credit institutions⁵ in the euro area and pursues the aims of stabilising money market interest rates, creating (or enlarging) a structural liquidity shortage and possibly contributing to the control of monetary expansion. The reserve requirement of each institution is determined in relation to elements of its balance sheet. In order to pursue the aim of stabilising interest rates, the ESCB's minimum reserves system enables institutions to make use of averaging provisions. Compliance with the reserve requirement is determined on the basis of the institutions' average daily reserve holdings over a one-month maintenance period.

1.4 Counterparties

The ESCB monetary policy framework is formulated with a view to ensuring participation of a broad range of counterparties. If minimum reserves are applied, only institutions subject to minimum reserves according to Article 19.1 of the ESCB/ECB Statute may access the standing facilities and participate in open market operations based on standard tenders. If no minimum reserves are applied, the range of counterparties broadly corresponds to credit institutions in the euro area⁸. The ESCB may select a limited number of counterparties to participate in fine-tuning operations. For outright transactions, no restrictions are placed a priori on the range of counterparties. For foreign exchange swaps conducted for monetary policy purposes, active players in the foreign exchange market are used. The set of counterparties for these operations consists of those institutions selected for ESCB foreign exchange policy operations which are located in the euro area.

1.5 Underlying Assets

Pursuant to Article 18.1 of the ESCB/ECB Statute, all ESCB credit operations (i.e. liquidity-providing operations) have to be based on adequate collateral. The ESCB accepts a wide range of assets underlying its operations. A distinction is made, essentially for purposes internal to the ESCB, between two categories of eligible assets: "tier one" and "tier two" respectively. Tier one consists of marketable debt instruments fulfilling uniform Monetary Union-wide eligibility criteria specified by the ECB. Tier two consists of additional assets, marketable and non-marketable, which are of particular importance for national financial markets and banking systems and for which eligibility criteria are established by the national central banks, subject to ECB approval. No distinction is made between the two tiers with regard to the quality of the assets and their eligibility for the various types of ESCB monetary policy operations (except that tier two assets are normally not used by the ESCB in outright transactions). The eligibility criteria for underlying assets to ESCB monetary policy operations are the same as those applied by the ESCB for underlying assets to intraday credit. Furthermore, ESCB counterparties may use eligible assets on a cross-border basis, i.e. they may borrow from the central bank of the Member State in which they are established by making use of assets located in another Member State.

1.6 Modifications to the Monetary Policy Framework

The Governing Council of the ECB may, at any time, change the instruments, conditions, criteria and procedures for the execution of ESCB monetary policy operations.

Table 1. ESCB monetary policy operations

Monetary policy operations	Types of transactions		Maturity	Frequency	Procedure
	Provision of liquidity	Absorption of liquidity
OPEN MARKET OPERATIONS
Main refinancing operations	• Reverse transactions	-	• Two weeks	• Weekly	• Standard tenders
Longer-term refinancing operations	• Reverse transactions	-	• Three months	• Monthly	• Standard tenders
Fine-tuning operations	• Reverse transactions • Foreign exchange swaps	• Foreign exchange swaps • Collection of fixed-term deposits • Reverse Transactions	• Non-standardised	• Non-regular	• Quick tenders • Bilateral procedures
	• Outright purchases	• Outright sales	-	• Non-regular	• Bilateral procedures
Structural operations	• Reverse transactions	• Issuance of debt certificates	• Standardised/ non-standardised	• Regular and non-regular	• Standard tenders
	• Outright purchases	• Outright sales	-	• Non-regular	• Bilateral procedures
STANDING FACILITIES
Marginal lending facility	• Reverse transactions	-	• Overnight	• Access at the discretion of counterparties
Deposit facility	-	• Deposits	• Overnight	• Access at the discretion of counterparties

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2.	It should be noted that national central banks of Member States which have not adopted the single currency in accordance with the Treaty retain their powers in the field of monetary policy according to national law and are thus not involved in the conduct of the single monetary policy.
3.	Throughout this document, the term "national central banks" refers to the national central banks of the Member States which have adopted the single currency in accordance with the Treaty.
4.	Throughout this document, the term "Member State" refers to a Member State which has adopted the single currency in accordance with the Treaty.
5.	The ECB might, if it decides to apply reserve requirements, review the range of institutions subject to reserve requirements. Selecting a broader range of institutions than credit institutions would require an amendment of Article 19.1 of the ESCB/ECB Statute. This could be brought about by the simplified amendment procedure specified in Article 41 of the ESCB/ECB Statute.
6.	The different procedures for the execution of ESCB open market operations, i.e. standard tenders, quick tenders and bilateral procedures, are specified in Chapter 5. Standard tenders are executed within a time frame of 24 hours from the tender announcement to the certification of the allotment result. All counterparties fulfilling the general eligibility criteria specified in Section 2.1 may participate in standard tenders. Quick tenders are restricted to a narrower set of counterparties and are executed within a time frame of one hour. The term bilateral procedures refers to any case in which the ESCB conducts a transaction with one or a few counterparties without using tender procedures. Bilateral procedures include operations executed through stock exchanges or market agents.
7.	Preparatory work is being carried out with a view to enabling the ESCB to impose minimum reserves as from the start of Stage Three. However, as for the other parts of the monetary policy framework, it will be up to the Governing Council of the ECB to decide whether minimum reserves will actually be applied.
8.	It is not excluded that, irrespective of the application of the ESCB's minimum reserves system, the ECB will decide to accept as counterparties additional institutions if they are relevant for the purposes of transmitting monetary policy.

ECB - European Central Bank