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13 - Restoring Credibility
- Kjell G. Nyborg, Universität Zürich
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Summary
And indeed there will be time
… for a hundred indecisions,
And for a hundred visions and revisions,
Before the taking of a toast and tea.
—T.S. Eliot, The love song of J. Alfred PrufrockIn this chapter I argue that the pathology at the heart of the euro crisis is a lack of credibility arising from the prerogative of sovereignty. The implication is that restoring credibility necessarily must involve reining in sovereignty. A brute force approach to this is a fiscal, or full-blown political, union. Below, I propose a milder approach that targets issues that pertain more specifically to the credibility, or integrity, of the common currency. My proposal offers a different vantage point for thinking about the problems of the common currency than the standard optimal currency area approach.
On the face of it, the euro area gives the appearance of being paralyzed by indecision. The same treaty comes and goes, revisiting the same old points. Here we have the Maastricht Treaty, there the Stability and Growth Pact, and yonder comes the Treaty on Stability, Coordination, and Governance with its Fiscal Compact. The maximum debt and deficit ratios are the same, but the penalties for crossing them vary, now weakening, now getting stronger. Convergence criteria are still on the table for member states, more than a decade after the inception of the euro and two decades after the Maastricht Treaty because, as seen in Table 12.1, official thresholds are not adhered to.
At the same time, despite a no-bailout clause in the Maastricht Treaty, bailouts of member states have become an integral part of the fabric of the euro. For some countries, the bailout processes never seem to end. The reason for all this is not indecision as such, but the prerogative of sovereignty that makes it almost impossible to reach final agreements.
References
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5 - Haircuts
- Kjell G. Nyborg, Universität Zürich
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Summary
This chapter documents in detail the haircut policy of the Eurosystem and how it has evolved over time. A detailed description of haircuts necessarily also provides further information on the large range of collateral that banks can use to obtain credit from the Eurosystem and how eligibility rules have been relaxed over the course of the financial crisis. The chapter ends by presenting evidence on the Eurosystem's haircuts across different types of collateral versus those applied in two widely used and comparable central counterparty (CCP) contracts.
DOCUMENTATION AND OVERVIEW
The ECB provides a list of documents that describe the collateral framework, including the rules for collateral eligibility and haircuts, on a dedicated webpage. These documents are also published in the Official Journal of the European Union and represent legally binding acts or decisions. In addition to the publication date itself, each of these documents shows the date when the act, or decision, was legally adopted. These “adopted on,” or formal approval, dates should not be confused with press-release dates; the ECB sometimes communicates decisions by the Governing Council through press releases before they become legal acts, if at all. When describing the haircut rules in this chapter, and the ratings rules in the next, I have relied on the contents of the legal documentation provided by the ECB on its webpage and published in the Official Journal.
The earliest dated collateral framework document posted on the ECB's webpage is the Guideline of the European Central Bank of 31 August 2000 on monetary policy instruments and procedures of the Eurosystem (ECB 2000/7). The preamble to this document establishes that it is produced under the “Treaty establishing the European Community”:
The achievement of a single monetary policy entails the need to define the instruments to be used by the national central banks of Member States that have adopted the euro… The ECB is vested with the authority to establish the necessary Guidelines for the implementation of the single monetary policy and the NCBs [National Central Banks] have an obligation to act in accordance with such Guidelines… ECB Guidelines form an integral part of Community law.
ECB (2000/7, p. 1)
Collateral Frameworks
- The Open Secret of Central Banks
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Central bank collateral frameworks are an often overlooked feature of monetary policy that play a key role in the monetary and financial system. Readers will discover how central banks conduct and implement monetary policy beyond merely setting interest rates, and develop their understanding as to how collateral policies may affect financial markets, financial stability, and the real economy. This book studies the collateral framework in the euro area in detail, and levers this analysis to provide an account of the euro crisis from the perspective of collateral policy. Readers gain access to a wealth of institutional and economic data and information with a level of density and accessibility unavailable elsewhere. This book, the first of its kind, is a valuable read for academic monetary and financial economists, those working in banking and policy-making financial institutions, and anyone who wishes to learn more about the role of central banks in society.
14 - The Problem with Collateral
- Kjell G. Nyborg, Universität Zürich
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Summary
In the wake of the financial crisis, there have been numerous proposals for “fixing” the financial system. Many of these place increased demand on collateral. It is therefore important to realize the limitations of collateral as a problem-solving tool. In this chapter, I draw on the insights and findings from previous chapters to discuss some of the more obvious problems with systems that place large demand on collateral. In this context, I discuss two high-profile topics, namely the interbank market for liquidity and the resurrection of the 1930s-era “Chicago Plan” of full reserve banking.
THE FUNDAMENTAL PROBLEM
The fundamental problem with collateral is that there is a limited amount of it that can be considered “good.” Financial systems that place large demands on collateral may face a shortage of high-quality collateral. Furthermore, as demand for collateral increases, more of it will have to be rated, or assessed in some way, and monitored. This is expensive. The ratings process is also fraught with problems, as touched on in Chapter 6. The lower down the quality scale one must go, the larger are the problems associated with the ratings process likely to be.
Collateral serves a valuable purpose because it reduces concerns about default and may therefore increase the willingness of counterparties to trade. This effect is a function of the liquidity of the underlying collateral. Securities that cannot be traded in the market, except at heavy discounts relative to fundamentals, are not suitable as collateral. The point with collateral is that losses can be covered in case of counterparty default. It is therefore important to note that there is not an active market for most securities.
As discussed in Chapter 7, conservatively estimated based on information in the Bloomberg system, only about 20 percent of the securities that are on the Eurosystem's public list of eligible collateral are sufficiently actively traded that they have fresh market prices, or quotes, on a daily basis. Furthermore, even if a security has a daily updated market price, it does not mean that arbitrarily large quantities can be traded at that price. It is well documented in the market microstructure literature that limited depth is ubiquitous in financial markets.
2 - Collateral Frameworks: Overview
- Kjell G. Nyborg, Universität Zürich
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Summary
Central bank collateral frameworks are fundamental institutional features of the monetary and financial system that have gone largely unstudied by researchers, perhaps because they are simply taken for granted and seem of little consequence in times of “normalcy.” They are also often complex and opaque, requiring the studying of numerous legal documents to be accurately understood. Their basic function is to define the set of eligible collateral financial institutions can use in operations with central banks to obtain central bank money (liquidity). They also determine the quantity of liquidity that a central bank will supply for each eligible collateral, by, for example, setting haircuts in repos with eligible counterparties (“banks”). This places collateral frameworks at the core of the monetary system and the financial system that extends (from) it.
This chapter provides an overview of the role played by collateral frameworks and how they function in practice, with an emphasis on potential biases and distortions that may arise from their design. These issues are then investigated in subsequent chapters through a forensic-style analysis of the Eurosystem's collateral framework. The current chapter also previews the key findings of that investigation. A central characteristic of the Eurosystem's collateral framework is its broad eligibility criteria. The findings in this book are especially relevant with respect to understanding potential issues that arise in collateral frameworks sharing this characteristic. My general point is that collateral frameworks have potentially far-reaching effects on financial markets and the real economy. They are at the core of the monetary system and, as observed by Bagehot, “[m]oney is economical power.”
An important strand of the monetary economics literature focuses on the distinction between what economists call “inside and outside money” (Gurley and Shaw 1960). The former can be defined as “an asset representing, or backed by, any formof private credit that circulates as a medium of exchange,” with the latter being “money that is either of a fiat nature (unbacked) or backed by some asset that is not in zero net supply within the private sector of the economy” (Lagos 2006). According to Blanchard and Fischer (1989, chapter 4), “currency and bank reserves, high-powered money or the money base constitute outside money.”
3 - Monetary Policy Implementation in the Euro Area over Time
- Kjell G. Nyborg, Universität Zürich
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The collateral framework is a part of the monetary policy framework. Through its monetary policy operations, a central bank provides central bank money against eligible collateral, as determined by the collateral framework. To put the role of the Eurosystem's collateral framework in context, this chapter sketches out the main features of the ECB's monetary policy framework and updates to these over time. It also provides data on the magnitudes of the ECB's operations over time and therefore the value of collateral that needs to be pledged by banks, in the case of repos, or purchased. This is then compared to the monetary base and the Eurosystem's consolidated balance sheet, which helps to illustrate the centrality of the collateral framework.
Table 3.1 lists the main instruments of monetary policy implementation in the euro area and significant modifications to these from January 1999 to January 2015. The ECB's basic approach is to use reverse operations that inject liquidity into the banking sector through repos, or collateralized loans. Banks’ counterparties in these transactions are their respective national central banks (NCBs). Some NCBs operate with systems where the pledged collateral is earmarked for a particular operation, but most use a pooling system in which the total collateral value of each bank's collateral inventory account with its NCB is used to cover all its loans across all operations. For example, a bank that has outstanding repos, or loans, of 1 billion needs to have eligible collateral with an official collateral value of at least 1 billion in its collateral pool, or account. Subject to the eligibility and value constraints, banks have complete discretion over what collateral they pledge in Eurosystem operations.
Each new reverse operation offers banks the opportunity to refinance, or roll over, maturing repos (or loans). They are therefore referred to as refinancing operations.
Table 3.1 delineates the evolution of the two most important types of refinancing operations, namely the main refinancing operations (MROs) and the longer-term refinancing operations (LTROs). The MROs were initially run as fixed rate tenders with a limited allotment.
List of Exhibits
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Preface
- Kjell G. Nyborg, Universität Zürich
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Summary
This book seeks to inform about a feature of monetary policy that is largely overlooked yet occupies a central role in the monetary and financial system, namely central bank collateral frameworks. They are much like G.K. Chesterton's famous “invisible” postman in that, like him, collateral frameworks are out in the open and utilized every single day of the year, but nevertheless go largely unnoticed. Unlike the postman, however, collateral frameworks are obscured by opacity. Those that care can look up the nitty-gritty of how collateral frameworks work by studying the relevant official documentation, but it is not trivial reading. Furthermore, to understand how collateral frameworks actually function, it is not sufficient to merely read the official rules, it is also necessary to supplement these with empirical facts that shed light on how those rules are implemented and what their consequences are. This book does both. Its main objective is to bring the importance of collateral frameworks more out into the open.
I do this through an in-depth study of the collateral framework of the euro area. This is an especially interesting case because of the banking and sovereign debt problems in the euro area and the ongoing efforts of the European Central Bank (ECB) to, in Mario Draghi's words, preserve the euro. The Eurosystem's collateral framework provides a novel and useful frame of reference for looking at the unfolding crisis. The book shows that the collateral framework is integral to the unconventional monetary policies pursued by the ECB in its bid to stave off the crisis. The book also lays out the general pattern of the ECB's unconventional policies to preserve the euro and shows that these involve indirect bailouts of banks and sovereigns, with some countries benefiting more than others.
As I thought I was nearing completion of this book in January 2015, several “euro events” occurred in rapid succession that I felt compelled to incorporate into my analysis because they reduced uncertainty with respect to future ECB actions to preserve the euro. This has led to a chapter on the endgame of the euro crisis to go along with a chapter on the euro's fundamental credibility problem and what to do about it.
Acknowledgments
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4 - Evidence on the Production and Usage of Collateral
- Kjell G. Nyborg, Universität Zürich
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Eligible collateral comes from many different asset classes, ranging from government bonds to asset-backed securities. Non-marketable assets can also be eligible. This chapter reports on the nominal amounts of eligible collateral across different marketable asset classes from 2004 to 2013. It also reports on banks’ actual usage of collateral across these asset classes and non-marketable assets. By comparing the usage data with the eligible collateral value data, it is possible to get a sense of the extent to which there are biases in the collateral framework. If all eligible collateral have the same opportunity costs, we would expect to see no distinct preference for using collateral from particular asset classes. Thus, in this chapter, I compare the fraction of eligible collateral that is used across asset classes.
Table 4.1 provides the nominal value of eligible marketable collateral from 2004 to 2013. The data are compiled by the ECB and available on its webpage (see the caption of Table 4.1). The ECB provides the data broken down into seven asset classes. These are, from top to bottom in the table, central government securities, regional government securities, supranational and agency securities (“other marketable assets”), covered bank bonds, corporate bonds, uncovered bank bonds, and asset-backed securities. As will be shown in Chapter 5, collateral haircuts in the Eurosystem are increasing in these asset classes in the order just cited. Thus, we can think of these asset classes as having decreasing “quality” in terms of risk and liquidity, as reflected by haircuts.
Table 4.1 shows that, in aggregate, the nominal value of eligible marketable collateral has nearly doubled from 2004 to 2013, going from EUR 7,646 to 14,183 billion. These are relatively large numbers in comparison with the size of the ECB's operations and balance sheet as well as the monetary base, as discussed above. For example, the nominal value of eligible marketable collateral in 2013 is approximately 19.8 times the amount lent through the ECB's operations (item 5 on the balance sheet) and 10.9 times the combined size of item 5 and item 7 (outright collateral holdings).
11 - Bailing Out the Euro
- Kjell G. Nyborg, Universität Zürich
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Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
– Mario Draghi, President of the ECB, Speech at the Global Investment Conference in London July 26, 2012This declaration speaks volumes as to the threat the euro was, and continues to be, under. The first signs of the problems to come emerged in August 2007 with the advent of the broad financial crisis. In the eurozone, this latermorphed into a sovereign debt crisis and its corollary, a crisis of the euro itself, that is still not fully resolved. In this chapter, I examine some of the key measures taken by the ECB to deal with the banking and sovereign debt crisis in the euro area and the ongoing work to preserve the euro. The potency of some of these measures derives from the richness of the underlying collateral framework.
That the euro would eventually encounter difficulties was not a surprise to many economists. The potential problems with having a common currency for a dispersed set of countries such as those in the euro area have been articulated numerous times by several commentators, including one of the most influential macroeconomists of our times, the late Milton Friedman, who viewed the introduction of the euro as a mistake. In August 2002, he reiterated this point by saying that “I will be surprised if you do not have very serious problems arising in the next five years or so among the 12 countries in the euro regime.” As we now know, Friedman's prediction came true.
The unconventional monetary policies introduced by the ECB in response to the crisis are outlined in Table 3.1 and reviewed in Chapter 3. The main focus in the current chapter is on the full allotment policy (October 2008) and on the asset purchase programs announced in the ECB press conference on September 4, 2014. The former facilitated a growth in the ECB's balance sheet by around EUR 1 trillion, and there were indications from Draghi on September 4, 2014, that the new asset purchase programs being introduced would have similar impact.
Contents
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7 - Market and Theoretical Prices
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Summary
As shown in Equation (2.1), the collateral value of a security in Eurosystem operations is its market, or in some cases, model, price less its haircut. The rules that determine whether a market or theoretical (model) price is used are laid down in the official documentation of the Eurosystem's collateral framework. As one would expect, there are separate pricing rules for marketable and nonmarketable collateral. This chapter describes changes to these rules over time, with a focus on marketable collateral. Non-marketable collateral is discussed toward the end. The chapter also provides evidence on the incidence of theoretical prices, initially in terms of the public list of eligible marketable collateral. This is followed by an estimate of the incidence of theoretical prices among pledged collateral.
ELIGIBLE MARKETABLE COLLATERAL
From January 1, 2007, to January 2, 2013, the pricing rule for marketable collateral was:
Pricing rule 1
The value of a marketable asset is calculated on the basis of the most representative price on the business day preceding the valuation date. If more than one price is quoted, the lowest of these prices (normally the bid price) is used. In the absence of a representative price for a particular asset on the business day preceding the valuation date, the last trading price is used. If the reference price obtained is older than five days, or has not moved for at least five days, the Eurosystem defines a theoretical price.
ECB (2006/12)This passage reveals that both stale and theoretical prices are built into the collateral framework. Theoretical prices are used if market prices do not exist or are too stale, that is, more than five days old over the 2007–2012 time period. The pricing rule before 2007 was similar, but without the five-day staleness limit (ECB 2000/7 and 2005/2). The combination of haircuts that are rarely revised (Chapter 5) and stale or theoretical prices has the potential to create biases, along the lines of those documented in Chapter 4.
12 - The Endgame of the Euro Crisis
- Kjell G. Nyborg, Universität Zürich
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Summary
The endgame of the euro crisis began with the confirmation in the ECB press conference on January 22, 2015, that the Eurosystem would buy sovereign bonds. This was introduced on the back of the ABS and covered bond purchase programs announced September 4, 2014, and discussed in the previous chapter. This combined, or expanded, asset purchase program represents what central bankers refer to as quantitative easing, meaning that the purchases of the assets are financed by the creation of new (electronic) central bank money.
The exact timing relates to an interim opinion by the European Court of Justice on January 14, 2015, regarding the legality of the ECB's Outright Monetary Transactions (OMT) program to buy sovereign bonds of troubled countries (ECJ 2015a). The opinion, issued by Advocate General Cruz Villalón, states that the OMT program is, in principle, within the ECB's mandate. Importantly, the Advocate General's opinion speaks not only to the legality of the OMT, but to the buying of sovereign bonds in general. His opinion is that it is within the ECB's mandate to do so, under certain basic provisos I will discuss in Section 12.2. In short, the ECB was given an amber, if not a green, light to start buying sovereign bonds. The signal was strong enough that a major buyer of euros, the Swiss National Bank, took immediate action and ended its three-year-old peg to the euro the next day. The formal announcement that the Eurosystem would start buying sovereign bonds took place at the very first opportunity one week later, the scheduled press conference associated with the Governing Council meeting on January 22.
There are four elements to this chapter. It starts by providing some broader background to the fiscal sandbox of the euro area. It then goes on to discuss the ECJ's interim opinion on January 14 and the ECB's announcements on January 22, 2015. Following on from this, I discuss some scenarios as to how events may unfold as a result of the Eurosystem's expanded asset purchase program.
10 - Market Discipline
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Market forces and discipline are important notions in the context of collateral frameworks for several reasons. As illustrated by Equation (2.1) and Figure 2.1, collateral values are determined by applying haircuts to, in principle, market prices. Furthermore, market discipline is typically viewed as an important complement to financial regulation. It is one of the three pillars in both the Basel II and III bank regulation frameworks (BCBS 2011). The idea is that banks, like other enterprises, should be regulated not only through formal regulatory rules, but through the competitive forces of the market. More generally, market and competitive forces are central to the efficient allocation of capital and resources. We would expect this principle to be relevant also in the case of the market for liquidity and the money creation process.
An issue raised in this book, however, is that markets are utilized to a relatively small degree by the Eurosystem's collateral framework. Indeed, it appears that many features of the framework are designed to circumvent market discipline. Chapters 5 to 9 offer much by way of detail that speaks to this. The current chapter distills these findings and discusses some of the consequences of the relative lack of market discipline allowed for by the Eurosystem's collateral framework.
MARKET DISCIPLINE IMPAIRMENT
Several features of the Eurosystem's collateral framework impinge on market discipline. Some of the most noteworthy of these are listed below.
First, non-marketable assets are included in the set of eligible collateral. Thus, banks can obtain liquidity without having themselves or their assets assessed in the market. The evidence shows that the usage of non-marketable collateral has increased in the euro area over time, reaching approximately 10 percent in 2007 and more than 20 percent in 2011 where it has remained (Figure 4.1).
Second, a substantial fraction of marketable collateral on the public list of eligible collateral trades on non-regulated markets (more than 30 percent, Table 9.1). One might expect prices in such markets to be fairly unreliable as compared with regulated markets. This view is supported by the evidence in Table 7.1 that the incidence of theoretical prices is much higher for collateral trading on non-regulated markets than for other marketable collateral.
9 - Non-regulated Markets, Unsecured Bank Debt, and LTRO Uptake
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From the beginning, the Eurosystem's collateral framework granted eligibility status to marketable securities traded on either regulated or non-regulated markets (ECB 2000/7). Regulated markets include exchanges such as the “Frankfurter Wertpapierbörse (Regulierter Markt)” operated by Deutsche Börse AG and “Eurex Deutschland” operated by Eurex Frankfurt AG in Germany as well as “Euronext Paris” and “MATIF” operated by Euronext Paris in France, or the “Wholesale Italian and Foreign Government Bond Markets (MTS)” operated by Società per il Mercato dei Titoli di Stato – MTS S.p.A. in Italy. On October 4, 2014, for example, the list included eighty-eight regulated markets.
Examples of non-regulated markets that are currently accepted by the ECB include the “STEP market” in the EU, the “French Medium-Term Notes (BMTN) market,” and “the unofficial market (Freiverkehr) of a German exchange.” On October 4, 2014, the list included twenty accepted non-regulated markets.
While securities could potentially trade on different types of markets, the initial collateral framework described in ECB (2000/7) specifies that collateral issued by credit institutions is only eligible if it trades on a regulated market, except in the case of covered bonds.
Thus, unsecured debt issued by credit institutions, or banks for short, trading on non-regulated markets was not eligible collateral, except in exceptional circumstances at the discretion of the Eurosystem.
This changed after the Lehman bankruptcy in the fall of 2008. In particular, as of October 25, 2008 (ECB 2008/11, Article 4):
Debt instruments issued by credit institutions, which are traded on certain non-regulated markets, as specified by the ECB shall constitute eligible collateral for the purposes of Eurosystem monetary policy operations.
Hence unsecured bank bonds trading on non-regulated markets are subject to eligibility from October 25, 2008. As shown in Table 5.2, bank debt trading on non-regulated markets was initially subject to an additional haircut of 5 percent as compared with corresponding instruments trading on regulated markets. This reflects the increased risk and illiquidity of such collateral. Nevertheless, this extra haircut was later dropped (see Tables 5.3 and 5.4). I will refer to the inclusion of unsecured bank debt trading on non-regulated markets into the public list of eligible collateral as the “non-regulated markets inclusion clause.”
8 - Collateral “Own Use”
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“Own use” of collateral is the case that a counterparty uses collateral (in a Eurosystem operation) issued by itself or an entity with which it has “close links.” As defined in the official documentation, close links are said to exist between two parties, A and B, (i) if at least one of the parties owns or controls, directly or indirectly, 20 percent or more of the capital or voting rights of the other, or (ii) a third party owns or controls, directly or indirectly, the majority of the capital or voting rights of both A and B. As of January 1, 2007, this is refined to include issuers, debtors, and guarantors (ECB 2006/12). In October 2008, the trigger level with respect to the third party in (ii) is changed from “majority of the capital” to “more than 20% of the capital of the counterparty [using the collateral in a Eurosystem operation] and more than 20% of the capital of the issuer/debtor/guarantor, either directly or indirectly, through one or more undertakings” (ECB 2008/13). Own-use collateral is sometimes also referred to as “retained collateral” in the official documentation.
With respect to eligibility, the baseline rule is that:
Despite their inclusion in the tier one list, National Central Banks shall not accept as underlying assets debt instruments issued or guaranteed by the counterparty, or by any other entity with which the counterparty has close links.
ECB (2000/7, p. 33).While this would make own use of collateral impossible, there are and have always been exemptions to the baseline rule.
The exemptions are initially laid out in ECB (2000/7). Specifically, footnote 45 of this document states that the prohibition against own-use collateral does not apply to
1. “close links between the counterparty and the public authorities of EEA countries;” ECB (2003/16, footnote 52) adds the following parenthetic clause to this: “(including the case where the public authority is a guarantor of the issuer)”; ECB (2008/13) adds that the public authority acting as guarantor should have “the right to levy taxes” and
2. “debt instruments which comply strictly with the criteria set out in Article 22(4) of the UCITS Directive (Directive 88/220/EEC amending Directive 85/611/EEC)” or “cases in which debt instruments are protected by specific legal safeguards [that are] comparable.”
Index
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List of Tables
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