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The European Central Bank — History, Structure, and the DecisionMaking ProcessRadek Foukal

Introduction

The European Central Bank (ECB) plays a major role in the European

Union’s economy as a whole. It is significant to recognize the start, and

development over the past decade, of the ECB. Central banks are

important in many economic aspects such as issuing bank notes,

changing interest rates and controlling money supply to keep liquidity

in the market. All these factors are prepared and managed by the three

bodies of the ECB: the governing council, which formulates the

monetary policy; the executive board, which implements the ECB

decisions, and finally the general council, which executes decisions with

all the national central banks of the European Union (EU). The ECB’s

main focus is on the price stability (inflation) and interest rates;

therefore, the whole process of policy making, which includes

preparations, discussions, decisions, communication, and

implementation, is the key of making an appropriate monetary policy.

Well managed banking is surely one of the most important

parts of every country’s economy. There are many institutions in the

economy that need to be managed, including commercial banks,

investment banks, and other large financial institutions. Management of

those entities of the economy requires some institution that will be in

charge. There is an institution that is designed to be in this special

position; that is a central bank. In recent history and the present, central

banks play major roles in real-world monetary systems.

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The Various Roles of the European Central Bank

There is one independent central bank that oversees not just one

economy but 27 of them. The ECB is located in Frankfurt, Germany.

The Central Bank operates as the main central bank for all European

Union members. First, the question is what makes an institution a

central bank? According to White (1999), economists have identified at

least six major roles for central banks, and they include:

1. Serving as a bankers’ bank

2. Having a monopoly of note issue

3. Acting as a lender of last resort

4. Regulating commercial banks

5. Conducting monetary policy

6. Managing the currency exchange

The role of serving as a bankers’ bank could be described as an

institution whose liabilities are held by commercial banks as part of

their reserves. Bankers’ banks can be also an economic device for

interbank money transfer. According to Goodhart, the typical central

bank gained its role of being a bankers’ bank over time (White, 1999).

A central bank was in a privileged legal position (as will be discussed),

as banker to the government in note issuing which brought about a

degree of centralization of reserves within the banking system, leading

to the role as bankers’ bank. Also the fact that a central bank was

supported by its home country government, gave it more power and

stability in that bankers’ bank position.

Monopoly of currency issue is another privilege of central

banks. In this case the ECB supplies bank notes into the Euro Zone,

though the euro coins are minted by the Euro Zone members. The fact

that central banks have a monopoly in issuing notes creates a lot of

responsibility for them and this is especially true for the ECB because it

issues notes for sixteen countries in the Euro Zone. The basic tenet of

currency issue is that if the central bank issues too many notes, it will

most likely lead to inflation; however if there is not enough liquidity in

the market it can lead to a liquidity crisis.

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Besides being a monopoly in issuing bank notes, central banks

have “secondary functions” of holding the banking system’s outside

money reserves and having the power to exercise control over credit

markets. Economic analysis has found that a monopoly of note issue is

not a natural monopoly, the product of economies of scale, but rather

the product of legislation. It comes into being as the result of

government and there is no reason to believe a single commercial bank

or any other type of bank would acquire a monopoly of note issue

absent government intervention. The ECB is not owned or supported by

any individual government; rather it is a private institution, endowed

with its position by the European Union.

The banking industries in the United States and Europe are

somewhat similar: there are both very large banks and many smaller

banks. The central bank function of regulation of commercial banks is

necessary because these private institutions are such a large part of the

economy. In these days in both the United States and Europe, it has been

suggested that the largest commercial banks should be regulated more

thoroughly than others, because as economists say “they are too large to

fail.” Basically what it means is if they were to go under the whole

financial system will go under. Another reason why banks should be

regulated is because it increases consumer confidence so that they are

more inclined to invest in what they perceive to be a more secure

financial system.

The ECB is not obligated to act as a lender of last resort but

large integrated economies such as the European Union need to be

running smoothly, because other countries around the world might be

dependent on that stability. Should a bank run into problems that

require it to borrow, and that borrowing cannot be satisfied in private

markets, the ECB may find that making credit available to that bank is

preferable to allowing the instability that might result from insolvency.

By not being required to act as lender of last resort, the ECB has the

ability to exercise judgment concerning which banks should be

supported and which might be beyond help.

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The monetary policy role of central banks plays an increasingly

important role in this international economy. The ECB uses monetary

policy to regulate the economy, through its influence on high powered

money and interest rates. High powered money, also known as the

monetary base, is defined as the currency held by the public and

reserves, that is vault cash held by banks and deposits of the banks held

in the central bank. Commercial banks can control the inflow and

outflow of commodity money; however they cannot control the quantity

of high powered money and that is why every country’s financial system

has a central bank that controls the main components in the system

(Mishkin, 2006).

The Evolution of the ECB and the Euro Zone

The ECB was established in June 1998 in Frankfurt, Germany. The ECB

formally replaced the EMI (European Monetary Institute) by virtue of

the Maastricht Treaty; however it did not exercise its full powers until

the introduction of the euro on 1 January 1999, signaling the third stage

of the development of the European Monetary Union (EMU). The EMU

was designated in its design to have one central bank, a free trade zone,

and one currency within the EU. The basic idea of the EU is to integrate

member countries economically and politically.

In order to have such a diverse union, there are certain rules

that need to be passed. According to the ECB the conditions to be fulfilled

before entering the EU are the Copenhagen criteria which require that

entering countries must have stable institutions guaranteeing democracy,

the rule of law, human rights, including respect for and protection of

minorities, and each country must have a functioning market economy

with the capacity to cope with competitive pressure.

Just as in many politically and economically unionized

countries such as the United States of America, the EU has the same

common goal, which is to make business transactions work more easily

and smoothly. One of the ways to achieve this goal is to use a common

currency as in case of the United States’ dollar. It would not be easy to do

business if people from New York had to exchange money to do business

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in New Jersey, and vice versa. When it comes to the EU, the theory of

making business and money transactions easier is accomplished with

the euro. The euro was launched as an electronic currency and

accounting unit in January 1999, and has been in circulation as a

currency since January 1, 2002 in Austria, Belgium, Finland, France,

Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain.

Other countries have since joined the Euro Zone including Greece,

Slovakia, Slovenia, Malta, and Cyprus. So the total number is 16 of the

27 member states of the EU (Feenstra and Taylor, 2008).

The ECB and the Euro Zone in theory and practice have

worked well so far. The ECB notes the benefits and advantages of the

euro, “with the establishment of Economic and Monetary Union, the EU

has made an important step toward completing the internal market.

Consumers and firms can now easily compare prices and find the most

competitive suppliers in the euro area, plus EMU is providing an

environment of economic and monetary stability all over Europe” which

stabilizes economic growth and the job market (ECB, 2006).

Traveling and tourism in the Euro Zone is another advantage of

having the same currency. People can compare prices for goods and

services in a foreign country, from their home country. Moreover with

the introduction of the euro, foreign exchange transaction costs and risk

were eliminated within the Euro Zone. The word integration is used a

lot in the European Union theory, because connecting all European

countries and treating them as a whole is the point of the venture. What

currency integration accomplishes, according to the ECB, in financial

markets is the following:

• The euro area’s interbank money market is fully integrated.

• The euro- denominated bond market is well integrated, deep

and liquid, and provides a wide choice of investments and

funding.

• The euro area equity market is increasingly viewed as single

market.

• Domestic and cross-border mergers and acquisitions have

increased among banks in the euro area

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All of these integration factors will positively affect economic

growth and will create more jobs (ECB, 2006).

Countries have to fulfill certain criteria that are set by the

Maastricht Treaty, as noted previously. The Maastricht Treaty laid out

four criteria that countries must meet to become eligible to join the Euro

Zone. First, a country’s inflation rate was not to exceed the average

inflation rate of the three best-performing member states by more than

1.5 percent. Second, long term interest rates were not to exceed by more

than 2 percentage points, the average of the three best-performing

member states. Third, the exchange rate of a country’s currency must

have stayed within the normal margins provided by the exchange rate

mechanism for at least two years, without devaluing against the currency

of any other member state. Fourth, a country’s government-deficit-to-

GDP ratio must not exceed 3 percent and its ration of government debt to

GDP must not exceed 60 percent (Dominguez, 2006).

Structure of the European Central bank.

The ECB is made up of three decision making bodies. These bodies are

the main one, the Governing Council, the Executive Board, and the

General Council also called general committee. The main role of the

Governing Council is to adopt guidelines and make decisions which

ensure the continued performance of the tasks of the Euro-system, and

to formulate monetary policy related to key ECB interest rates and

liquidity. The members of the Governing Council are the six members of

the Executive Board, plus the governors of the national central banks of

the 16 euro area countries (Feenstra and Taylor, 2008).

The Executive Board’s role is to implement of the monetary

policy of the ECB, prepare for meetings of the Governing Council, and

conduct the day-to-day business of the ECB. The board contains the

president (Jean-Claude Trichet) of the ECB , and four members that are

appointed on the basis of professional merit and monetary/ banking

experience, also three or four members of the Executive Board are from

the large countries (Germany, France, Italy, and Spain) (Feenstra and

Taylor, 2008).

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The General Council’s main role is to report on convergence,

contribute to the advisory functions of the ECB, the collection of

statistical data, the reporting activities of the ECB, and the laying down

of the conditions of employment of the staff of the ECB. The members

are the President and Vice-President of the ECB, plus the governors of

the national central banks (NCBs) of the 27 EU Member States. In other

words it includes representatives of the 16 euro area countries and the

11 non-euro area countries. The other members of the ECB’s Executive

Board, the President of the EU Council and a member of the European

Commission may attend the meetings of the General Council, but they

do not have the right to vote (Feenstra and Taylor, 2008). To sum up all

three decisions making bodies, governing council formulates, executive

board implements, and general council applies the monetary policy in

the all Euro Zone states.

Accountability and independence are the two main attributes of

the ECB, because without trust of people in the ECB, the idea of one

central bank for all members of the European Union would not work.

To earn trust from the public and the member states, the ECB set strict

rules for banks regarding of certain functions in the institutions.

Independence is viewed by many economists as a necessary

attribute of any central bank. In the EU, the ECB has sole monetary

policy powers; none are given to any other EU institution. No EU

institution has any formal oversight of the ECB, and the ECB does not

have to report to any political body, elected or otherwise. The ECB does

not release the minutes of its meetings (Feenstra and Taylor, 2008).

ECB independence means that it makes decisions regarding

monetary policy instruments used to achieve its goals. The instruments,

such as setting interest rates, are used with respect to its primary goal of

price stability. In the case of interest rates, the ECB sets “targets” believed

to be consistent with price stability. The often asked question is how the

central bank can stay independent and not to be influenced or pressured

by the member states. It is a multinational institution with difficult tasks

to manage, and one of those tasks is to not to make decisions, or act in

favor of, any member state. They have to make neutral decisions about

monetary policy by looking at the EU as a whole.

Instruments and Goals of the ECB

The monetary policy used by the ECB is a combination of understanding

the market and what the economy does when the ECB steps in, and

making changes at a certain point of the economic cycle. There is a set

of primary instruments used by the ECB.

The most basic instrument, used by the ECB, is the interest rate

at which EU banks can borrow funds. Since the ECB is highly

independent, the bank must follow certain rules that will prevent the

use of monetary policy to achieve other goals; the ECB may not directly

finance member states’ fiscal deficits or provide bailouts to member

governments or national public bodies. In addition, the ECB is not

required to act as a lender of last resort by extending credit to financial

institutions in the Euro Zone in the event of banking crisis although it

has the option to do that (Feenstra and Taylor, 2008).

Each member economy is constantly changing, because

underlying economic conditions in each country- like buyer’s

preferences, income, price level, political situation and the exchange-

currency markets- fluctuate. Recognizing this, the ECB uses its tools to

create stability in the union as a whole.

The main tool for affecting instruments like interest rates, are

open market operations. Open market operations include “temporary

lending of money for collateral securities (reverse operations or

repurchase operations, otherwise known as the ‘repo’ market). These

operations are carried out on a regular basis, where fixed maturity loans

for every month are auctioned off” (Kaplan, 2002). Also included in open

market operations are buying or selling securities (direct operations) and

foreign exchange operations such as for-ex swaps, which consist of two

legs- a spot and a forward exchange transaction- which are executed at

the same time for the same quantity and therefore offset each other. “All

of these interventions can also influence the foreign exchange market

and thus the exchange rate” (Kaplan, 2002).

The same kinds of interventions are used by other central

banks around the world. For example, the People’s Bank of China and

the Bank of Japan have on occasion bought several hundred billions of

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U.S. Treasuries, presumably in order to stop the decline of the U.S.

dollar versus the renminbi and the yen. The same transactions are

constantly happening with the euro.

Open market operations may be used for two basic situations;

expansionary policy is used for a sluggish economy and contractionary

policy is used when inflation threatens. The first scenario is when the

European economy is slow and needs a jump start to increase financial

and economic activity. In this case the ECB needs to step in and apply

its expansionary policy, which include raising money supply and

lowering interest rates the goals of which are encouraging investment

and increasing employment.

In order to make these changes to respond the market shocks,

the ECB uses the tools of monetary policy. According to White, the ECB

influences the money supply in the economy directly. Each time it buys

securities, exchanging money for the securities, it raises the money

supply. Conversely, selling of securities lowers the money supply (1999).

Open market operations are the primary tool of a central bank. Other

tools include:

1. Adjusting the interest rate on the main refinancing

operations (MRO), which provide the bulk of liquidity to the

banking system,

2. Adjusting the interest rate on deposit facilities, which banks

may use to make overnight deposits with the Euro system,

3. Adjusting the rate on the marginal lending facilities, which

offers overnight credit to banks in the Euro system, and

4. Altering the reserve requirements (the percentage of

deposits required held) for credit institutions (European

Central Bank, 2009).

The impact of manipulating these tools may be seen in

the following figure. In Figure 1, manipulation of interest rates has

the theoretic impact of increasing economic activity economy wide.

Enhancing money supply should help push down interest rates with

the following results.

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NominalInterestRate

quantityof

money

Figure 1: The Impact of Decreasing Interest Rates

Source: Feenstra and Taylor, 2008

The second scenario for the ECB occurs when the economy is

too “hot.” The ECB is able to use the contractionary monetary policy to

slow the economy down; here the money supply is reduced, interest

rates should go up, in turn causing investment to go down, and GDP

will go down as well. In order to do this, the ECB applies the same

monetary policy tools listed above, though in contractionary policy,

open market operations involve the sale of securities and raising of

rates. The impact on the money market of contractionary policy can be

seen in Figure 2, following.

Figure 2: A Contraction in the Money Market

Source: Feenstra and Taylor, 2008

Figure 11-7 Decreases in the Interest Rate Increases Aggregate Demand

Pric

e L

evel

(P)

Output (Y)

AS2

AD2AD1

P2

Y2Y1 YF

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The main goals of the ECB are to maintain price stability in the

European area and smooth out transactions in financial markets.

Specifically, “the primary objective of the ECB’s monetary policy is to

maintain price stability. The ECB aims at inflation rates of below, but

close to, 2 percent over the medium term” (European Central Bank,

2009). Some economists believe that the ECB’s decision to define price

stability so specifically might not give them much room when they

formulate their decisions. Having a certain target could bring pressure

on the ECB from forces outside the EU, and focus on just the inflation

rate may draw the ECB’s attention away from other important economic

issues like Gross Domestic Product performance, economic growth,

and unemployment.

A lack of focus on these other issues may have a particularly

negative impact on some member states. These economists, as well as

other policy makers and members of the public, argue that the ECB is

too “independent” compared to the U.S. Federal Reserve (the FED), the

U.S. central bank, which is obligated to ensure price stability and

achieve full employment. Moreover, the FED does not state an exact

inflation target which puts less pressure on their decision making

regarding the amount of credit in the financial system and the interest

rates. Central bank independence is a topic of ongoing economic and

political discussion. In light of the U.S. FED’s response to the recent

economic crisis, the U.S. Congress has raised questions about FED

independence.

Research into central bank independence suggests that

countries with greater central bank independence have experienced

lower inflation rates (White, 1999). The opposing argument is that a

central bank which is able to resist political demands is also able to

resist public accountability for choosing the wrong goals, choosing the

wrong techniques to attain those goals, and using the techniques

incompetently (White, 1999). The inflation experience of the EU is

detailed in Figure 3, following.

It is noted by Dominguez that, while the primary objective of

the ECB is stated as price stability, economic growth is mentioned as a

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secondary objective. Specifically, Article 105 of the Maastricht Treaty

defines that “the primary objective of the ECB shall be to maintain price

stability” and that “without prejudice to the objective of price stability,

the ECB shall support the general economic policies in the community”

(2006). The contrast with the FED’s objectives seemingly is one of

degree, rather than a complete distinction.

Figure 3: Harmonized Index of Consumer Prices (HICP)

Source: Eurostat, The European Central Bank.

Interest Rate Targets of the ECB

Besides controlling the money supply in the euro financial system, the

ECB deals with three main interest rates; they are the marginal lending

facility rate (discount window) which is the rate that the ECB offers

overnight credit to banks in the euro system, the main refinancing rate

which is the publicly visible interest rate that the central bank

announces. This is also known as minimum bid rate and serves as a

bidding floor for refinancing loans. The deposit rate is the rate parties

receive for deposits at the central bank.

In addition to its own interest rates, the ECB focuses on the

Euribor, which is the interbank interest rate. It is a rate at which EU

5

4

3

2

1

5

4

3

2

1

1995 2000 2005 2010

Start of Stage Three of BMU

HICP targetAverage inflation since 1999

banks lend money to one another within the Euro Zone- commercial

banks in the Euro Zone set this rate (The European Central Bank, n.d.).

Combining these rates together in Figure 4 illustrates how they relate to

each other. When there is confidence within credit institutions, the

Euribor is usually low; this is because credit institutions lend money to

each other when there is an environment of confidence, giving loans

and boosting investment, thus keeping liquidity in the market.

Conversely, when the rate is too high it indicates the opposite of high

confidence. This is the time when the ECB steps and uses one of its

monetary tools.

Figure 4: Various Interest Rates in the EU

Source: The European Central Bank, n.d.

Currently, the ECB is trying to respond to economic shocks. In

April 2009, ECB lowered the main refinancing rate to 1.25 percent, the

lowest ever at that point; by May 2009 this rate was lowered and

remains at one percent. On July 2008 the marginal lending facility rate

was 4.25 percent; by May 2009 this rate was down to 1.75 percent, down

from the highest borrowing rate from October 2000 to May 2001 at 4.75

percent. In fall of 2008, the deposit rate was 3.75 percent; it was down to

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European Central Bank interest rates and money market ratesMarginal lending rate, EurosystemOvernght deposit rate, EurosystemEurosystem: minimum bid rate in the main refinancing operations1-month EuriborEonia

6.0

5.0

4.0

3.0

2.0

1.0

0.0

%

2003 2004 2005 2006 2007 2008

Copyright Suomen Pankki - Finlands Bank 15.1.2008 - 221 - PTSources: European Central Bank and Reuters.

.25 percent by May 2009. This expansionary interest rate policy reflects

the world wide recession (The European Central Bank, n.d.).

Required Reserve Requirements: The Last Tool

The last tool of monetary policy is changing the minimum reserve

requirement “The reserve requirement is a bank regulation that sets the

minimum reserves each bank must hold to customer deposits and

notes” (Mishkin, 2006). The reserve ratio is sometimes used as a tool in

the monetary policy, influencing the country’s economy, borrowing, and

interest rates. The People’s Bank of China does use changes in reserve

requirements as an inflation-fighting tool and raised the reserve

requirements nine times in 2007. According to the ECB,Minimum reserves are an integral part of the operational framework

for the monetary policy in the euro area. The intent of the minimum

reserve system is to pursue 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 Eurosystem’s minimum reserve system enables institutions to make

use of averaging provisions. This implies that compliance with the

reserve requirement is determined on the basis of the institutions’

average daily reserve holdings over a maintenance period of about one

month. The reserve maintenance periods start on the settlement day of

the main refinancing operation (MRO) following the Governing Council

meeting at which the monthly assessment of the monetary policy

stance is pre-scheduled. The required reserve holdings are

remunerated at a level corresponding to the average interest rate over

the maintenance period of the main refinancing operations of the Euro

system. (European Central Bank, n.d.).

For the Euro area, the ECB sets two basic reserve requirements.

The first reserve requirement is two percent, set on overnight deposits,

deposits with agreed maturity or period of notice up to two years, debt

securities issued with maturity up to two years, and money market

paper. The second reserve requirement, currently zero percent, is on

deposits with agreed maturities, or periods of notice over two years,

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repos, debt securities issued with maturity over two years. A reduction

in reserve requirements is also an expansionary monetary policy.

The ECB has the power to make certain exceptions when it

comes to reserve requirements. Institutions that want to have this option

must request and fulfill certain conditions; “the institution has a special

function that would make the imposition of a minimum reserve

requirement run counter to the purpose of the system; and the

institution is subject to re-organizational measures. The ECB may also

exempt credit institutions from fulfillment of the euro system’s

minimum reserve requirements (without the need for a request to be

submitted via the correspondent central bank) in the reserve

maintenance period in which the institutions will cease to exist:

because its banking license is being withdrawn or surrendered, or

because it is subject to winding-up proceedings” (The European

Central Bank, n.d.).

Conclusion

In conclusion, being a central bank in a single country is not an easy

task, being a central bank in a union of 27 countries, 16 of which share

a common currency, is an extremely difficult task. The ECB has played

a major role in the European financial system and in many member

countries as well. The three main goals of monetary union, free trade,

one central bank, and one currency are already achieved in 16 out of 27

EU countries.

The three branch structure of the ECB makes the central bank

powerful and its management complex; it has total independence from

any of the governments in the EU, but it also must find some degree of

consensus on basic policy decisions between large numbers of member

state representatives. Such consensus is required for the design and

implementation of monetary policy that will be applied to a large

number of very different economies.

The Bank’s ability to use the basic monetary tools such as

controlling money supply, setting interest rates, and reserve

requirements would be difficult under any circumstances; when such

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decisions impact all member states, each with its own economic

conditions and issues, using such tools become particularly difficult. In

spite of the fact that the ECB is a relatively young institution and the EU

itself is evolving, most economists think that the ECB has managed its

role as a central bank well throughout its brief existence.

References

Dominguez, K. M. E. (2006, October). The European central bank, the euro, and

global financial markets, Vol. 20, No. 4.

Retrieved April 12, 2009, from JSTOR database.

The European Central Bank. Home page.

http://www.ecb.int/home/html/index.en.html.

Feenstra, E.R., and Taylor, M.A. (2008). International macroeconomics.

New York, NY: Worth Publishers.

Kaplan J. (2002). The Federal Reserve and monetary policy.

Retrieved April 5, 2009, from

http://images.google.com/imgres?imgurl=http://www.colorado.edu/Economics/

courses/econ2020/section11/gifs/fig117.gif&imgrefurl=http://www.colorado.edu/

Mishkin S. F. (2006). The economics of money, banking, and financial markets.

New York: Prentice Hall.

Moutot P., Jung A.,and Mongelli F. P. (2008). The workings of the eurosystem,

monetary policy preparations and decision-making (Rep. No. 79).

Frankfurt, Germany: The European Central Bank.

White, L. (1999). The theory of monetary institutions.

Hoboken, NJ: Wiley-Blackwell.

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