In brief

• ECB Executive Board member Isabel Schnabel warns that rising public debt and the growth of non-bank financial institutions could limit the freedom of monetary policy.
• Higher interest rates increase debt servicing costs, and France is particularly vulnerable.
• Some of the new bonds end up in highly leveraged funds, which may deepen market volatility and force fire sales.

Public debt and the freedom of monetary policy

The ECB is raising interest rates to curb excessive inflation. However, higher rates increase debt servicing costs, raising concerns that, with high levels of debt, some budgets may become unsustainable. France is particularly vulnerable. The fear of triggering financial instability may narrow the bank's room for manoeuvre when choosing its decisions (Rising debt, non-bank finance may limit ECB policy flexibility, says Schnabel - The Economic Times – indiatimes.com) (High Debt & Non-Banks Threaten ECB Monetary Policy, Schnabel Warns – globalbankingandfinance.com) (High debt, rise of non-banks risk tying ECB's hands, Schnabel says | Miami Herald – miamiherald.com).

Debt in the hands of non-bank institutions

Public debt has been rising since the beginning of the century, and a significant share of new bonds is going to entities outside the banking sector, including hedge funds. Schnabel points out that some of them may operate with high financial leverage.

Faster transmission and a threat to markets

Changes in ECB rates now reach markets faster, which may increase volatility. When the value of collateral falls and margin requirements rise, leveraged investors may be forced to sell bonds.

Possible central bank intervention

Schnabel warns that, in order to restore the transmission of monetary policy, central banks may be forced to stabilise markets before a liquidity crisis turns into a credit crisis. Such actions, however, may conflict with the bank's mandate and weaken the primacy of monetary policy.

Regulatory conclusions

Schnabel highlighted the need for stronger supervision of lenders outside the banking sector.