Indexation, explained

Under today’s announcement, banks borrowing from the ECB’s final 12-month liquidity offering would pay a one-off interest payment, of as yet unknown value. They would adopt the loan on December 16, 2009, and pay back both principal and interest at maturity all in one go, on December 23, 2010. The indexed interest payment will be the average minimum bid rates of the 53 weekly ECB auctions over the life of the loan. And in case that isn’t clear, here’s the formula:

In these auctions, called main refinancing operations, the ECB typically allots capital to banks offering the highest rates, until the supply is exhausted. The supply is determined by the ECB based on market conditions. However, since October 2008, the bank has been offering unlimited funds at a fixed rate, doing away with the need for the auction. Today the ECB confirmed this practice would continue “as long as needed” and at least until April 13, 2010.

If the fixed rate policy were to continue for the whole of 2010 – unlikely – then the interest payment of December’s issue of funds would be the average of those fixed rates. If, however, the auctions are resumed, the interest rate of December’s issue would be the average of some fixed rates (under the current scheme) and some minimum successful bid rates (under the auction scheme).

This is a smart move, as Ralph has previously explained. Had the rates for 12-month liquidity been fixed, they would either have been the current rate, or a higher rate. Since the ECB is expected to raise rates within the life of the loan, a current rate could have been interpreted as a loosening of policy; conversely an increase in rates could have been interpreted as tightening. But under indexation, borrowers should not expect to receive funds more cheaply than if they had entered into the weekly auctions.

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