This week the ECB allocated €529 billion to 800 banks in its second 3-year Long-Term Refinancing Operation (LTRO).  Together with December’s €489 bln allotment, banks have now borrowed over a trillion euros of 3-year money much more cheaply than they could have borrowed from bond investors.  Procedures are also now in place to allow eurozone banks from 7 countries (Portugal, Ireland, Italy, Spain, Cyprus, Austria and , interestingly, France) to use their loan books as collateral - Draghi said at this week’s ECB press conference that €53 bln of loan collateral was posted (led by French banks which posted €40 bln).

Given the success these 3-year LTROs are having in both solving the banks’ worries about refinancing their maturing debt and the beneficial effect they are also having in normalising Europe’s sovereign debt markets, it is difficult to see why the ECB will not launch further 3-year LTROs in due course until the demand for them subsides once eurozone banks have sated their appetites for cheap secured financing.  Draghi stressed at his last press conference that there was no stigma to banks using the LTROs and hinted that the LTROs were needed because the interbank market is not functioning properly right across the eurozone (the senior unsecured bank bond market is not working too well either).  This means that the LTROs could be with us for a very long time as it could be years before e.g. German banks will be willing to risk lending unsecured short-term money to banks located in the PIIGS countries.  Draghi also highlighted that the second LTRO was especially useful to smaller banks which typically finance SMEs – the same SMEs which provide 80% of the employment across the eurozone.  Notably 430 out of the 800 borrowing banks were small German banks located in towns and villages across Germany, although they accounted for a lot less than 54% of the €529 bln borrowed.

Big companies with access to the ECB via their financing subsidiaries (e.g. Volkswagen) also took advantage of the LTROs as well as UK banks such as LLOY using the cheap money to help fund their non-core Irish assets.  The ECB also seems to be happy that the LTROs have supported the peripheral sovereign bond markets to such an extent that it has stopped buying bonds through the Securities Markets Programme – now the ECB can turn its attention to extricating itself from the €219 bln pile of bonds sitting in the SMP.

It will pay investors to keep playing “Follow the Money” in 2012, as the 800 eurozone banks did not borrow €529 bln off the ECB with the idea of leaving it on overnight deposit at the ECB for the next three years.  €820 bln is currently on deposit at the ECB and the banks will surely use a big chunk of this to redeem their maturing bonds during the rest of 2012.  However if they start to lend any of this money into the real economy then it will show up via rising reserve balances which they must hold at the ECB – this figure on the ECB’s balance sheet currently stands at €91 bln (liability item 2.1 on the RHS).

The banks with surplus euros on deposit at the ECB are highly likely to be big banks located in core eurozone countries as companies including GSK and VOD have said they are sweeping cash out of weaker eurozone countries at the close of business every day (and the core banks also have nervous Greeks, etc. depositing their euros to avoid a possible currency devaluation).  Any non-trivial risk of a country leaving the euro will cause all sensible companies and individuals to move money to banks located in the eurozone’s core countries as fast as possible.  Understandably these banks just leave it on deposit at the ECB because this hot money could easily move on again at short notice (so the banks can’t tie it up by lending it to businesses and households).  As the banks use the LTRO money to pay back their maturing debt, the investors who owned that bank debt are going to have to find somewhere else to re-invest the €600 bln proceeds.  Follow the money.