Asset management

30 September 2013

Economist Insights Let’s (LT)ROll again
The ECB’s Long-Term Refinancing Operations (LTROs) have contributed significantly to the calmer markets in Europe. The LTROs successfully brought down EONIA, the interest rate that banks charge each other for unsecured lending. Now European banks are paying back the money they borrowed under LTRO, removing excess liquidity from the system. Will the ECB introduce another LTRO? The uncertainty about whether shrinking excess liquidity is a good or a bad thing is likely to make the ECB wait and see before it decides on another LTRO. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management

Gianluca Moretti Fixed Income Economist UBS Global Asset Management

A casual observer could be forgiven for thinking that the Eurozone crisis is over: borrowing costs are low and markets seem complacent. The European Central Bank has contributed significantly to the improvement in two ways: its promise to backstop any increase in yields that could threaten the survival of the euro (the Outright Monetary Transactions, or OMT); and the provisioning of cheap funding for banks through the 3-year Long-Term Refinancing Operations (LTROs). The LTRO has been the ECB’s answer to quantitative easing (QE). Outright QE would have been politically difficult because it looks like direct funding of government debt, so the LTRO was an alternative way to increase the ECB’s balance sheet. At its peak, the LTRO was almost 10% of GDP, measured as the ‘excess liquidity’ in the system (see chart 1).
Chart 1: Evaporation Excess liquidity (EUR bn) 800

While the US Federal Reserve has shied away from slowing the speed at which it increases its balance sheet (so-called ‘tapering’ of QE), the ECB has seen its own balance sheet shrinking. The ECB’s full allotment system means that it is the banks who decide the size of the LTRO (unlike QE where the Fed decides). Banks have been paying back their LTRO borrowings, which for the Eurozone is the equivalent of the Fed not just slowing or even stopping QE but actually selling off its stock of QE. No wonder then that ECB President Mario Draghi raised the possibility of another LTRO. The LTROs are a little more complicated than QE. Before the first 3-year LTRO was introduced in December 2011, banks could get as much funding as they wanted from the ECB for up to 3 months (provided they had collateral). But banks want the certainty provided by longer-term borrowing and to better match the maturity of their borrowing to the maturity of their lending. The LTRO was good at bringing down one of the most important interest rates in the market: EONIA, which is the rate that banks charge each other for unsecured lending. It was so successful that it even pushed EONIA below the ECB’s main policy rate. Most of the LTRO funds ended up in the Eurozone periphery because most banks in the core had already accumulated a lot of liquidity (that in the past they would have loaned to the periphery). Now that banks are paying back their LTRO, the amount of excess liquidity in the system is shrinking. Since the excess liquidity was responsible for reducing EONIA, there is now a risk that EONIA will rise again. This could then mean higher borrowing costs for households and firms which would be bad for growth. Does this make another LTRO a sure thing? Not necessarily.




0 2008






Source:Excess ECB liquidity Note: Excess liquidity is defined as the sum of the deposit facility and the current account minus the reserve requirements and the marginal lending facility.

Falling excess reserves might not be all bad news. The ECB, through the LTRO and its other operations, was pretty much the sole source of funding for many banks in the periphery at the height of the crisis. If these banks are now paying back the LTRO because they can once again access market funding then this would be good news. For example, if banks in the core are willing to resume interbank lending to the periphery then the financial sector is becoming less fragmented. Liquidity in the system would be used more efficiently. Unfortunately there is also a less optimistic interpretation. If banks are shrinking their balance sheets by reducing lending to households and firms then they do not require so much liquidity – hence they pay back the LTRO. This is equivalent to a tightening of monetary policy, which is the last thing the Eurozone needs while facing spill-overs of tightening monetary conditions from the US. The two LTROs are due to expire in December 2014 and March 2015, so banks that are reliant on this funding may worry that they will be unable to replace it with private funding in the future. This could be one reason for them to start shrinking their balance sheets in preparation. The uncertainty about whether shrinking excess liquidity is a good or a bad thing is likely to make the ECB wait and see before it decides on another LTRO. If the fragmentation of the banking system is not reversing, then by the middle of 2014 we would likely see serious tensions building up in the interbank market. Paradoxically, introducing another LTRO too early may cause the fragmentation of the banking system to persist; if banks can get cheap long-term secured funding from the ECB, they are less likely to borrow from core banks or the market even if they could.
Chart 2: Anticipation Eonia 1y rate, Eonia 1y1y forward, ECB policy rate (%) 2.5 2.0 1.5 1.0 0.5 0 2011 EONIA 1y

If there is a possibility of tension in the interbank market, we would expect the market to start pricing that in. In addition to the 1-year EONIA rate that covers the next 12 months, we can look at what the market is pricing in for the 1-year EONIA over the subsequent 12 months (the 1y1y forward) because this covers the period when the LTRO is expiring. This forward 1-year EONIA rate has indeed been rising above the current 1-year EONIA rate since May (see chart 2). The ECB may start to worry more if the forward rate rises above the current ECB policy rate because this would be a sign that bank borrowing costs will rise once the LTRO expires. For the moment the ECB may be cautious about introducing another LTRO quite quickly. Since the tensions in the EONIA market remain quite moderate, there is a risk of low participation in another LTRO. This might be interpreted by the market as a failure of monetary policy, potentially forcing the ECB into another rate cut to make up for the lost impact. Justifying an LTRO from a macroeconomic perspective would be a challenge at the moment. True, the recovery has remained weak but it has been strengthening of late. As long as the ECB’s forecasts for inflation over the next two years continue to show subdued inflation when they are updated in December, it is more likely that this will be used to justify more dovish forward guidance on rates than to trigger another LTRO. In many ways the LTRO is more about dealing with risks than with changing the stance of monetary policy. Nonetheless, there are conditions under which the ECB may decide on an earlier LTRO. If there is strong evidence that excess liquidity is only shrinking because banks in the periphery are shrinking their balance sheets, the ECB may need to step in to give the banks confidence that they can fund for the longer term through a new LTRO. Another LTRO could also be effective at reinforcing forward guidance in the event the ECB can’t control spill-overs from the US when the Fed starts tapering. The forthcoming ECB audit of the banks could also justify the need for another LTRO. If this review of asset quality forces banks to recognise more loans as non-performing, then their borrowing cost will go up. The need to provision for those loans could force banks to sell assets. In such a scenario, a new LTRO could provide banks with cheaper liquidity and reduce the incentive to reduce their balance sheet. Even though another LTRO could have unintended negative consequences, the potential benefits are likely to convince the ECB. Since the financial crisis central banks have been willing to accept the risks of a policy even when the benefits are uncertain, and the ECB is likely to take that gamble and roll again.

2012 EONIA 1y1y forward

2013 ECB Repo rate

Source: ECB, Bloomberg Finance L.P.

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