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Natixis ECB Report

Natixis ECB Report

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Published by: Japhy on Jul 20, 2010
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What will be the impact on liquidity of the EUR 442bn LTRO reaching maturity
The first 12-month long-term refinancing operation (LTRO) matures this Thursday. At EUR 442bn, this meansthat nearly half the liquidity provided by the European Central Bank (excluding covered bond purchases) isbeing withdrawn. While a 3-month tender and a fine-tuning operation (FTO) at 1% are being staged as a bridgeuntil the next main refinancing operation (MRO), there remains to be seen how the expiry of the 12-monthLTRO will affect: (1) Eonia rates; and (2) sovereign spreads within the Eurozone. There will be less excessliquidity, which ought to push up Eonia rates, albeit gradually. As collateral will be returned, this may triggersome selling, causing spreads to widen although the possibility to roll at 1% via the European Central Bank’sweekly tender ought to limit the extent of this selling.
When the European Central Bank staged the 12-monthLTRO back in 2009, this led to a very sharp increase in theliquidity made available to banks. The lasting disconnectionbetween the repo rate and Eonia shows there really wasexcess liquidity swilling about. The question now is how thebanks will behave come the roll on 1 July 2010.More generally, will banks arbitrage between the differentmaturities? Or will banks be tempted to lock in liquidity? Whatarbitrages will there be between asset classes (bonds, asset-backed securities, etc.)? Finally, what will be theshort/medium-term impact on the Eonia-repo spread?
Liquidity before redemption of the 12-month LTRO
Significant excess liquidity has been provided by theEuropean Central Bank. By excess liquidity, we mean thesurplus liquidity in relation to autonomous liquidity factors andreserve requirements, which are normally what steer liquiditymanagement by the central bank.
Liquidity requirementscurrently amount to around EUR 600bn
(autonomousliquidity factors for EUR 390bn and reserve requirements forEUR 213bn).The European Central Bank currently provides EUR 878bn,in addition to which it has purchased EUR 60bn of coveredbonds that have not been sterilised. While the central bankhas said that it does not intend to make further purchases ofcovered bonds, it will keep in portfolio the bonds purchasedto date and will probably keep them until maturity. In otherwords, EUR 60bn has been advanced to the banks for keeps.On the other hand, the EUR 55bn of debt instrumentsacquired in connection with the European bailout plan do notenter into the equation since these purchases have beentotally sterilised.All in all,
the European Central is providing almostEUR 940bn of liquidity
, i.e.
EUR 340bn more than isstrictly needed by the European banking system
ECB - Excess liquidity
-5005010015020025030002/99 02/01 02/03 02/05 02/07 02/09-50050100150200250300350
Sources : Bloomberg 
 This is reflected in the overnight deposits at the EuropeanCentral Bank, which towered at more than EUR 305bnyesterday.
ECB- Deposit facility at 0.25%
02000040000600008000010000012000014000016000018000020000022000024000026000028000030000032000008/07 12/07 04/08 08/08 12/08 04/09 08/09 12/09 04/10020000400006000080000100000120000140000160000180000200000220000240000260000280000300000320000
Source : ECB, Bloomberg 
 With the EUR 442bn 12-month LTRO reaching maturity,nearly half the liquidity provided by the European CentralBank will be withdrawn on 1 July. In theory,
the surplus
June 30, 2010 – No.157Authors: Jean Francois RobinEvariste Lefeuvre
No 157 - 29 June, 2010 I2
liquidity experienced by the Eurozone could give way toa liquidity shortfall
. As we go on to explain, this will nothappen and measures are being taken to prevent thechangeover from being too chaotic.
Benefit for the banks of participating in 12 –month LTRO
The 12-month LTRO was arranged when the interbankmarket was experiencing very serious strains andanticipations regarding short rates were clearly on the upside.Much of the EUR 442bn allocated to 1,100 banks must beanalysed as a desire to benefit from this windfall by locking inliquidity at 1%. This is in stark contrast to the situation now.
Liquidity will remain abundant even after withdrawingEUR 442bn
The EUR 442bn of collateral released when the 12-monthLTRO expires will not vanish into thin air. This collateral couldbe recycled at the weekly MROs (kicking of this week with a6-day fine tuning operation), which are being done at a fixedrate and for unlimited amounts, also at the 3-month LTROscheduled for 1 July. One can therefore expect theseoperations to be well bid.Accordingly, the 6-day FTO, 3-month LTRO and MROs arelikely to balloon in size. Banks will need time to see how bestto employ the collateral lodged for the last year at theEuropean Central Bank.That was the case at yesterday’s MRO maturing on 7 July, away therefore of anticipating the redemption, whenEUR 162.9bn was allocated to the 157 bidding banks.In terms of size, the MROs are likely to exceed EUR 200bn,and the 3-month LTRO could well approach this level (resultsdue to be released today at 11.20 am).
How to apply the collateral retrieved?
One can expect part of the collateral scraped together by thebanks last year will now find its way back into the market.
Quality collateral
is unlikely to find its way back to theEuropean Central Bank, and while it may take several weeks,it will probably be sold or used in interbank repo market.In this respect, the European Central Bank’s own liquidity islikely to decline. On the other hand, liquidity in the interbankrepo market could increase.Banks, notably in Greece, Portugal, Spain and some inGermany, that are finding it hard to obtain refinancing, willcontinue to seek refinancing not in the interbank market butat the European Central Bank by lodging each week thecollateral retrieved when the 12-month LTRO matures.Several scenarios can be envisaged (see below). One canimage there being no rolls from the 12-month LTRO into theMROs and for demand to reach EUR 150bn at today’s MRO,but the most likely scenario in our view is that there will be apartial roll today through the 3-month LTRO and the MROscould be increased up to EUR 200bn. If EUR 150bn isallocated at the 3-month LTRO and MROs were once againto average EUR 250bn, there would once again be significantexcess liquidity compared with theoretical requirements(frozen at current levels for this purpose).This may appear a little optimistic but the reality is likely to besomewhere between these two extreme scenarios, witharound EUR 100bn of excess liquidity probably left in thesystem.
Excess liquidity will be reduced, possibly by EUR 150-200bn, but excess liquidity there will still be
The European Central Bank clearly does not want to imposerestrictive conditions given the strains experienced by theinterbank market and the effects this is having on certainbanks and certain countries.
Could the end of the 12-month LTRO cause a widening ofsovereign spreads?
Clearly, the impact will not be a tightening but rather awidening.While it is difficult to determine precisely the extent to whichthe collateral consists of sovereign debt instruments, one canwager that government bonds represent at least 20%. In2006, the collateral consisted for 21% of government bonds,a proportion that went on to decline to 10% in 2008. Giventhe upturn in sovereign risk, it is likely that the proportion ofgovernment bonds has increased sharply. With the repo ratestanding above the interbank offered rate, banks will tend togive the European Central Bank securities that will not bereadily accepted as collateral in the interbank repo market (in2008, asset-backed securities accounted for much of thesecurities provided as collateral to the European CentralBank).It is in the banks’ interest to offer as collateral the least liquidand lowest rated securities, therefore Greek, Portuguese andSpanish government bonds. More liquid securities can beoffered as collateral easily enough in the interbank repomarket.For the lowest rated securities, i.e. GGBs, the EuropeanCentral Bank has announced that it was accepting allsecurities issued or guaranteed by the Greek State with nominimum rating criterion. It is therefore likely that GGBsretrieved by banks will be offered as collateral to theEuropean Central Bank or sold in the market.The others will be kept because they are can be used morereadily as collateral in the interbank repo market.
ECB – Excess liquidity with continuous adjustment of MROs
Banking system’s theoretical requirementEUR 150bn allotted at 3m LTRO
No allotment at 3m LTRO
EUR 150bn at 3m LTRO + EUR 250bn rolled into MROs
Source: Bloomberg 
No 157 - 29 June, 2010 I3
Banks having lodged non-core securities as collateral withthe European Central Bank and which are able to obtainrefinancing in the interbank market (at 0.33% on 29 June) willprobably look to unload securities that cannot be used readilyas collateral in the repo market.However selling GGBs at current levels, therefore at a loss,may not do marvels for the banks’ P&L.As these securities may not be readily accepted in repos,banks are likely to provide them as collateral for the 6-dayFTO and then roll them at the MROs to begin with (which iswhy the 3-month MRO is expected to be very well bid).
One can imagine that refinancing 3-year GGBs yielding11% at 1% is an excellent strategy in terms of carry.
Iflosses are going to be incurred when marking to market, onemight as well play the carry.For portfolios accounted for as loans and receivables, nottherefore valued on a market-to-market basis, for which the“only” risk is a default before maturity, there is also lessurgency to unload.Selling is thus likely to be the preferred course of action butthis should be limited to begin with.Markets for certain securities such as GGBs will not bereopened totally, meaning that such securities may wellcontinue to be refinanced at the European Central Bank inthe meantime. However, there is the risk that at each bid inthe market, those banks that have seen their limits reducedsince July will be tempted to sell the securities. This wouldreduce in proportion bids at the European Central Bank’sMROs, hence the liquidity in the system since theseoperations are on a full allotment basis.
Impact on Eonia
Eonia rates are clearly set to trend upwards in comingmonths, with these rates gradually converging towards repo,probably more quickly than is being priced currently.Nonetheless this process will take place gradually, maybeover several weeks of MROs and could end only in 2011.
Eonia swap rate 1 month forward on ECB dates
Jul Aug Oct Dec Feb Apr Jun Aug Oct DecJul Sep Nov Jan Mar May Jul Sep Nov2011Eonia curve
Natixis ECB repo scenario

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