3yr LTRO: Breaking or strengthening the banking/sovereign feedback loop?

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.

Looking forward

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.

15 Responses to 3yr LTRO: Breaking or strengthening the banking/sovereign feedback loop?

  1. Bill says:

    Forgive me asking, but once the ECB receives the Trash assets, where do they get the cash to deliver to the banks? Is it new money in effect created by the ECB for the purpose? Bill

    • Megan Greene says:

      The 3-year LTROs are not sterilised, so the money is effectively new and results in some minor form of small scale quantitative easing.

      • Ramanan says:

        Hi Megan,

        Yes, the ECB has not said anything about sterilizing but I guess reserves will automatically reduce if they are higher than banks’ liquidity needs.

        For example, you may see some banks – presumably stronger ones – reducing their indebtedness to their home NCB when they have higher reserve balances. i.e., you may see them progressively bid for less funds in future MROs (which amounts to retiring their old refinancing from the Eurosystem).

      • Joanna says:

        How can you call this ” some minor form of small scale” it is the biggest LTRO that the European Central Bank has done! 489 billion Euros.

        It is also bigger than the current programmes of the US Federal Reserve and the Bank of England.

      • Elliott says:

        Hello Megan,

        I greatly appreciate your insights into the LTRO. Like Bill, I am also unclear on where exactly the funding is coming from to fund the LTRO. Obviously, the ECB is providing it, but where is the ECB getting it from?

        I read one article which mentioned that member nations of the EU are providing contributions to the fund, and this is where at least some of the funding is coming from. But does this account for the whole amount?

        If, as you say, there is some form of quantitative easing going on with this, this implies that money is being created. As I understand it this means someone somewhere is issuing new bonds, and somebody else is buying them. But what bonds and who is buying them?

  2. C High says:

    Thanks Megan. The take up by banks today has been massive. FT Alphaville have titled this ECB wheeze ‘All you can eat cheap money’. Does this mean the 19 December plan to send funds from the eurozone to the IMF still goes ahead?

    • Megan Greene says:

      The 3-yr LTRO will help to relieve stress in the interbank markets, but it does little to fundamentally alter the EZ debt crisis. It seems likely the IMF will still be involved in a big bazooka to remove Italy and Spain from the markets for about 15-18 months.

      • Nobby says:

        I think the mythical big bazooka is about as real as the Loch Ness Monster.

        The announcement the EFSF will come in under €300bn, plus the European contribution to the IMF only reaching €150 bn, the statements out of US and China plus the legal restrictions with the ECB suggest it is not plausible to take Italy and Spain out of the markets for 18 months…..

  3. JB says:

    Megan, do you think the risk of a banking crisis, over the next six months, is over with then – in terms of the risks of a European bank failing? There was more take-up, today, of the ECB’s 3 year LTRO than swap line use during the depths of the 2008 crisis.

    • Megan Greene says:

      Today’s 3-yr LTRO operation will play a significant role in easing the stress in the interbank markets, but I think it’s too early to say whether the risk of a banking crisis is off the table. I think EZ GDP is already contracting from Q4 2011, and banks will have to deleverage to meet their new core tier I capital ratios by mid-2012. The longer term LTRO will minimise the deleveraging, but deleveraging seems unavoidable nevertheless. The ECB’s 3-yr LTRO operation certainly helps, but in my view it is not a game-changer as far as the EZ crisis is concerned.

  4. Pingback: Great blog on the Euro debt crisis | The OTC Space

  5. FrankSz says:

    If private debt is decreasing, because of demographic trends, asset bubble implosion, etc., and if this is going to go on for a long time, then does mean that the public are effectively saving? Does this in turn mean that the long term outlook is that states will have to run deficits at least as high as that effective saving rate?

  6. TIP says:

    This reads like “money printing” to me.

    How do you think this affects the ECB’s crediblity – specifically with its single mandate towards price stability and specifically with the German public?

    Did Merkel purposefully exaggerate German fears of inflation in the negotiation for treaty change?

    Have German taxpayers been genuinely hoodwinked into bailing out peripherals – not through direct contributions to the EFSF but rather indirectly through the endurance of more abrasive inflation?

    I’m finding the radio silence on this massive monetary measure a little strange…

  7. Pingback: La BCE met à mal les prévisions des experts | weeko

  8. C High says:

    Megan, just thought you might be interested in reading Mats Persson’s views on the ECB situation. Interesting blog article in Daily Telegraph. Realise you are very busy but looking forward to your next post!


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