Before the global financial crisis of 2008, the European Central Bank (ECB) operated a monetary policy framework known as the interest rate corridor model. This model managed short-term market rates by setting an upper limit (Marginal Lending Facility Rate, MLFR) and a lower limit (Deposit Facility Rate, DFR). The main refinancing rate was positioned in the middle of this corridor. The ECB guided short-term market rates to align with the main refinancing rate through open market operations. In this framework, the banking system reserves were kept at lower levels, enabling the ECB to effectively control interest rates and liquidity conditions, ensuring the smooth transmission of monetary policy to the real economy.
However, the outbreak of the global financial crisis in 2008 altered the macro-financial environment, leading to difficulties in monetary policy transmission. The U.S. subprime mortgage crisis triggered global liquidity stress, restricting banks' asset liquidation and liquidity management capabilities, with banks gradually leaning on the ECB as a liquidity source. Concurrently, short-term rates in the euro area became volatile, market confidence in the ECB's control waned, sovereign debt rates in peripheral countries continuously increased, and financial conditions tightened further.
To address these challenges, the ECB implemented quantitative easing after the financial crisis, shifting its monetary policy framework from the interest rate corridor model to a "floor system." Under this system, the ECB met banks' liquidity needs at a fixed refinancing rate without limit and expanded the list of eligible collateral to increase market liquidity supply. To provide more long-term, stable liquidity, the ECB introduced one-year and three-year Long-Term Refinancing Operations. Additionally, the ECB launched the Covered Bond Purchase Programme (CBPP) and the Securities Markets Programme (SMP), purchasing bonds from primary and secondary markets to help banks restore long-term financing functions and reduce the risk premium on member states' sovereign debt.
These measures successfully helped the ECB regain control over short-term interest rates and stabilized market spreads. However, the "floor system" also brought new challenges. Firstly, the reduction of policy rates to match the corridor's lower limit blurred the lines between fiscal policy and monetary policy, raising concerns over fiscal deficit monetization. Secondly, the ECB's large-scale bond purchases reduced the number of bonds available for trading in the market, creating a scarcity of high-quality collateral. Quantitative easing also depressed bond yields, possibly altering market risk pricing and the allocation of financial resources, affecting bond market liquidity. Lastly, excess liquidity reduced interbank unsecured money market activity, making bank reserve needs unstable, and increasing sensitivity to the relative returns of banks' investments in other products.
Overall, while the ECB's transformation of its monetary policy framework effectively addressed the post-global financial crisis liquidity crisis, it also exposed potential risks in policy transmission, bond markets, and bank trading behavior. In the future, the ECB will need to continue adjusting its strategies to tackle possible economic uncertainties and financial market fluctuations.
