3yr LTRO: Breaking or strengthening the banking/sovereign feedback loop?
December 21, 2011 15 Comments
The 3-year LTRO was announced by ECB president Mario Draghi following the December governing council meeting, alongside (among other things) a drop in collateral requirements at the ECB. These measures were designed to short circuit the endless feedback loop between sovereigns and banks by sticking the ECB right in between them. The idea is for banks to offload questionable assets from their balance sheets in exchange for cheap liquidity from the ECB, which banks can use to lend and invest as banks are meant to do. Will attempts to break the circular reference between sovereigns and banks and prevent the interbank markets from freezing succeed with this new 3-year LTRO, or will banks take advantage of the carry-trade and strengthen the feedback loop?
Prospects for the carry-trade?
Shortly after the 3-year LTRO operation was announced by the ECB, French President Nicholas Sarkozy indicated that banks could use the facility to load up on more sovereign debt. Banks could repo assets at the ECB in the 3-year LTRO and in exchange receive funds at a cost of around 1%. They could then use those funds to purchase sovereign bonds that have a much higher yield (Italian and Spanish bonds are around 6.5% and 5%, respectively). This process could be repeated as long as banks have assets to repo, and given that the ECB just dropped its collateral requirements significantly, there are seemingly few assets the ECB would reject as collateral. In theory, the ECB could fund near-unlimited sovereign debt purchases this way. This sort of carry-trade could be extremely dangerous, because it not only fails to break the banking/sovereign feedback loop, it actually strengthens it. If there is a sovereign default, banks will only be more decimated by it if this kind of carry-trade occurs on a widespread scale given that they will be holding more sovereign debt.
How likely is this? Small- and medium-sized banks that already have a lot of exposure to domestic sovereign debt could decide they may as well double down and take advantage of the sovereign-debt carry-trade. Spanish and Italian banks may also use the 3-year LTRO to purchase domestic sovereign bonds under pressure from their respective governments. Furthermore, banks may choose to buy peripheral sovereign debt because it is cheaper than using the ECB’s deposit facility or buying safer German sovereign debt.
A question of risk
The 3-year LTRO will undoubtedly be used by some banks to purchase sovereign debt, but mostly it seems the operation will be used mostly to fund bank’s existing asset holdings. According to the last European Banking Authority (EBA) stress tests that were published on December 8th, European banks have sold off €65bn of peripheral sovereign debt over the past nine months. The EZ crisis has only intensified over the past 9 months, with EU leaders failing to devise a way to draw a line under it. Without a turning point in the crisis, why would banks pull a 180 degree turn and start buying peripheral sovereign debt again?
Banks are also likely to shun peripheral debt in case the crisis worsens. Sovereign debt held in trading books must be marked to market. If the crisis worsens, banks will face margin calls on the bonds used to raise cash in ECB repo operations. Banks will also have to post more capital if the sovereign whose debt has been pledged is downgraded by a credit rating agency, which seems very likely. The amount of additional capital banks would have to find would rise even further if the EBA were to hold another stress test that imposes a haircut on sovereign debt and demands additional capital for potential losses.
A bank reporting a rise in peripheral sovereign debt holdings will probably have more difficulty finding funding in the private markets. Furthermore, it seems likely that banks boosting their peripheral sovereign debt holdings could be downgraded by credit ratings agencies.
Rather than parking sovereign debt at the 3-yr LTRO window, it seems banks may increasingly take advantage of the lower collateral requirements to draw liquidity from the ECB. Banks may begin to issue their own debt, receive a government guarantee for it for a small fee and repo it in the longer-term LTRO window for cheap financing. There may not be a lot of this sort of collateral pledged on December 21st because it takes some time to put into place and the lower collateral requirements were only announced on December 8th. I think we will see a lot more of this in the next 3-year LTRO operation. Additionally, final approval of the budget law in the Italian senate later this week will include a provision for Italian banks to procure a government guarantee for debt that they issue. This means that Italian banks could use their own debt as collateral in the February operation as well.
The take-up of the 3-year LTRO on December 21st will provide an important boost to market confidence that the ECB has addressed liquidity concerns in the banking sector if it is big. Even more telling, however, will be the take-up at the February long-term LTRO operation.