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This paper tests two alternative hypotheses for the overbidding behavior of the banks in the fixed rate tenders conducted by the European Central Bank (ECB) from January 1999 until June 2000. One hypothesis attributes the overbidding to the expectations of a future tightening of monetary policy, while the other attributes it to the liquidity allotment decisions of the ECB. The model is estimated with individual bidding data of the Spanish banks, and also with aggregate bidding data of all Spanish banks and all banks in the euro area. The empirical results provide support for the second hypothesis.

The monetary policy instruments used by the European Central Bank (ECB)1 are (i) minimum required reserves, (ii) open market operations, and (iii) standing facilities. The minimum reserves help to ensure that the euro area banking system has an aggregate liquidity deficit which is covered by two main types of open market operations: the main refinancing operations and the longer-term refinancing operations. The former (latter) are liquidity providing collateralized transactions with a weekly (monthly) frequency and a maturity of two weeks (three months). The banks can also obtain or place overnight liquidity at the marginal lending and deposit standing facilities.

We have tested two hypotheses that have been put forward to explain the overbidding behavior of the banks in the fixed rate tenders conducted by the ECB from January 1999 until June 2000. The expectations hypothesis attributes the overbidding to the expectations of a future tightening of monetary policy that led the banks to increase their current demand for liquidity in order to reduce the cost of holding reserves over the maintenance period of the reserve requirement. On the other hand, the tight-liquidity hypothesis explains the overbidding by the fact that the ECB kept interbank rates above the tender rate, which generated a profit opportunity for the banks that was increasing in the quantity bid. Our empirical analysis uses two interest rates as explanatory variables: the spread between the one-week Euribor and the tender rate and the spread between the one-month Euribor and the tender rate. The results show that once we control for the first spread, the effect of the second is small and statistically not different from zero. Hence the evidence supports the view that the reluctance of the ECB to let interbank rates fall below the tender rate played a crucial role in explaining why the banks overbid.