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.