The ECB Bridges the Gap with its Superwaffe.
Amidst all the sound & fury generated by last Friday’s EU summit (where the UK dug its heels in against the other 26 EU countries), the announcement the day before by the ECB that it is to offer unlimited 3-year money to euro-zone banks went largely unnoticed. Banks which take this longer-term refinancing operation (LTRO) 3-year money have the option to return it to the ECB at anytime after 12 months and only have to pay the interest at the end.
This long-term financing offered in unlimited size by the ECB is likely to turn out to be the ”superwaffe / bazooka” which the markets have been looking for, especially as the ECB has once again relaxed its collateral criteria – it will now accept A-rated ABS and performing bank loans.
In effect euro-zone banks are now free to finance as much of their loan books that they can convince their national central bank to accept as collateral, as well as financing for three years as many government bonds as they can buy (NB the current shape of many euro-zone yield curves has 2-year yields higher than 10-year yields). The banks will then have locked in profits (which will end up counting as Core Tier 1 capital) for the next 3 years. It was no coincidence that Spain this week sold €5 bln of 12-month debt for a yield which was a full percentage point lower than it sold 12-month debt for last month. Gold fell sharply this week too (falling $140) which is a sign of a crisis fading away.
Banks are going to start lending to their governments in real size, and the banks are going to finance this lending via the ECB’s 3-year LTROs. Draghi went out of his way during his recent ECB press conference to emphasise that there would be no monetary financing of governments by the ECB, but in effect there is no practical difference between the ECB buying unlimited amounts of euro-zone sovereign bonds via its SMP and euro-zone banks using the ECB’s unlimited 3-year financing to buy unlimited amounts of their governments’ bonds. The ECB will claim its provision of liquidity is temporary and the banks are taking the market risk but this will ring a little hollow when the ECB is effectively term-funding euro-zone banks’ holdings of euro-zone sovereign bonds with three years or less to run.
The EBA is unlikely to repeat its mistake of 26 October 2011 when its decision to force banks to raise Core Tier 1 capital ratios to 9% after marking sovereign bonds holdings to market prices worsened the panic in sovereign debt markets. The EBA has since performed a partial U-turn by “clarifying” that market prices as at 30 Sep 2011 (i.e. before the panic was exacerbated by the EBA’s own actions) will be used. We can expect that the EBA’s 2012 stress tests will be quite tame as it has already stated that forcing banks to mark their sovereign bonds to market prices is a one-off measure because the EFSF/ESM is expected to ease the distress in sovereign debt markets (although the EFSF’s job will become harder if/when France loses its AAA-rating).
When the results of the ECB’s first 3-year LTRO are announced on 20th December, the total size allotted will be the number to look out for. With these 3-year LTROs, banks are incentivised to pre-fund all their 2012 debt maturities and to finance their government’s borrowing requirements too. The market is currently worried about how the banks are going to roll-over the €230 bln in bank bonds maturing in Q1 2012 - the answer is going to be via the ECB at 1%.
The 20th Dec LTRO and the follow-up LTRO on 28th Feb 2012 may not be the only two 3-year LTROs we see the ECB conduct. The ECB is doing its job of looking after the banks and the banks in turn are going to look after their governments. It may not be the Big Bang announcement the market was looking for but the market is increasingly recognising that the ECB will bring out its “superwaffe” next week.
Tags: ABS, banks, bazooka, debt, draghi, EBA, ECB, efsf, esm, EU, France, Gold, LTRO, QE, SMP, sovereign, superwaffe, UK, yield curve
December 18th, 2011 at 5:32 am
Hi Antonne,
again a very interesting and delighting article from you!
My questions:
- Where do you see that this facility will be offered in unlimited amount to the banks?
- Can you please explain why this particular solution is more acceptable to ECB on a large scale? ECB does not buy sovereign bonds directly because it is against its mandate. German government opposing euro-bonds, because it would “collectivize debt”. Doesn’t this facility – if it would be used unlimited size – would mean taking the debt load to ECB (i.e. collectivizing debt) with a collateral equivalent or below the sovereign bonds?
Generally, are you sure that this facility is more than a liquidity measure, and ECB will indeed allow this to be used for large scale refinancing of sovereign debt?
December 20th, 2011 at 7:47 pm
Hi Gergely,
To respond to your points in turn:
1. The ECB announced this 3-year LTRO will have “full allotment” so it is unlimited because the ECB will give banks as much 3-year money as they ask for (and can provide collateral against). The link to the ECB announcement is in the first paragraph of my post above.
2. The ECB is happy with this solution precisely because the banks buy the sovereign bonds and the ECB just finances them (albeit for the next 3 years). It is semantics really – the ECB is providing an unprecedented amount of liquidity against a widened range of collateral but it is not actually printing money (importantly the Bundesbank can live with this).
3. Yes this facility does mean taking the debt load to the ECB with collateral equivalent to or less than sovereign bonds. We will discover just how much financing the ECB is providing tomorrow (with more to follow in Feb 2012). If the sovereign bonds fall in price then the ECB will demand more collateral from the banks but if the banks corner the market in a particular sovereign bond then its price won’t fall…
4. I don’t agree the ECB is “collectivising” the debt because the ECB is not guaranteeing the sovereign bonds which it will end up financing via these 3-year LTROs. The ECB is simply providing financing for an extremely wide range of collateral (which includes sovereign bonds).
5. In Draghi’s interview with the Financial Times (published 3 days after the above post) he says “one of the things banks may do with the money is buy sovereign bonds” – very plain speaking indeed for a central banker. The interview is published on the ECB’s website here.
Regards Antonne.
December 21st, 2011 at 9:51 pm
Hi Antonne,
1) Sorry for the naive question, but where does the ECB have this unlimited amount of money to lend? Isn’t that practically equivalent to quantive easing?
2) Can you please explain to us non-finance guys, under which circumstances do quantitive easing lead to inflation? Why it did not (yet?) cause inflation in case of US? Does it have to do something with the reserve currency status of the USD? Would that apply to Euro as well (in case of QE or similar techniques)?
Thanks!
Gergely
December 21st, 2011 at 11:14 pm
Hi Gergely,
It may help to think about the difference between physical cash (coins & banknotes in circulation) and money as represented by the balance of a bank account. Both are money because an individual can go to an ATM and empty their bank account of money by withdrawing it in the form of banknotes. Simplifying matters a little, what the ECB has done today is to allow 523 banks to deposit €489 bln of sovereign bonds (collateral) with the ECB and in turn to electronically credit the accounts of those 523 banks with €489 bln of money (a secured loan which the ECB wants repaid in 3 years time, with interest please). NB. The ECB has thus grown its balance sheet. It is true that the ECB also controls the amount of banknotes in circulation (it sends them to a bank when the bank requests them – and, just like an ATM, it reduces the bank’s electronic balance by the amount they have just physically withdrawn).
What the Fed does in its version of QE is to buy government bonds from banks and pay for them by electronically crediting the accounts of the banks. But the difference is this is not a loan and the Fed does not require the bank to pay back the money at a specified date in the future – the Fed now owns the Treasuries outright. NB. The Fed thus grows its balance sheet too.
This is where we get into semantics because both central banks have done the same thing in different ways – they have both grown their balance sheets by adding government bonds to one side of their balance sheet whilst crediting banks’ current accounts on the other side of their balance sheet. Personally I think this is the ECB’s version of QE which is why I have referred to it as the ECB’s “Superwaffe” in the above blog post. In Draghi’s interview with the FT (see link in point 5. above) he is asked directly whether this is Europe’s version of QE and he replies that “each central bank has its own rules and vocabulary…we call them non-standard measures”.
As to your question about inflation, one way of thinking about it is to say that inflation is defined as “an increase in the money supply”. Some people then go on to add “which leads to more money chasing a finite supply of goods & services which leads to an increase in their price (which shows up in the inflation rate, as measured by an index which has been created by the government)”. Crucially the circumstances in which QE or Superwaffe will lead to inflation require that the money which has been electronically deposited in banks’ current accounts at the Fed/ECB needs to find its way into the real economy – so people can then spend it on (a finite supply) of goods & services.
If it just stays on deposit at the Fed then it won’t enter the real economy and it won’t create inflation and this is precisely what we have seen in the States where the Fed has conducted $2.3 trillion of QE and banks’ deposits at the Fed are currently $1.6 trillion. Inflation works in the same way in all currencies whether they are US Dollars, Euros or Reichmarks – if the money supply in the real economy grows too quickly then the result is inflation. Just play “follow the money” (always an illuminating process) and see where it ends up.
Sorry for the lengthly reply. I recommend starting by looking at the ECB’s balance sheet as it is much more clearly presented than the Fed’s. LTROs show up in item 5.2 on the LHS and Banknotes in circulation are item 1 on the RHS.
Regards Antonne.