SERIOUS MONEY:THE NEAR meltdown that exposed the fragility of the global financial system four years ago put an alphabet soup of opaque exotic securities with acronyms such as CDO and CDS on the front pages of the print media.
The world’s major central banks responded to the systemic threat through the introduction of unconventional monetary policies with unfathomable abbreviations, including TAF, TSLF and PDCF.
Fast-forward to today and the European Central Bank’s (ECB) three-year LTROs are the latest irregular liquidity facility launched in an effort to ease mounting stress in the funding markets. The first-ever three-year refinancing operation has been deemed a success, as it not only stirred financial markets, but opened the wholesale term-debt market and prevented a troubling shortage of liquidity from degenerating into something far more destructive – a full-blown funding crisis across the euro zone’s banking system.
The monetary authority’s long-term refinancing operation is back in the spotlight once again, as the second round of auctions is scheduled to take place tomorrow.
Investment professionals are hoping it will prove as successful as the first, and thus, help to sustain the sharp rally in risk assets that gathered momentum at the end of last year.
Informed investors should question whether this is a well-grounded expected outcome. Before reaching conclusions, it is useful to examine the mechanics of how the ECB has conducted monetary policy before and after the financial tsunami struck.
In normal times, the principal tool the ECB uses to manage inter-bank interest rates is the provision of short-term loans to banks short of liquidity. This is conducted on a weekly basis via securities repurchase agreements – or repos – where the central bank accepts securities from a bank that are eligible, provides a short-term loan to the bank and, sells the securities back to the bank one week later at an agreed higher price.
This procedure takes place in a tender or auction, in which the ECB fixes both the amount of loans available and the minimum interest rate that banks will have to pay.
The funds are then rationed out to those banks that are willing to pay the highest rate. The minimum bid rate pre-announced in the so-called main refinancing operations (MROs) is the ECB’s key interest rate, which signals the policy-intended level for short-term money market rates.
During the crisis, the ECB increased the frequency of LTROs and introduced new long-term refinancing operations with maturities of one month, six months and 12 months. Additionally, the exceptional circumstances saw the monetary authority expand the list of collateral accepted, replace the pre-announced allotment volumes with full allocations and, conduct the LTROs at a fixed rate.
The first three-year LTRO last December was conducted under the same guiding principles but for the further relaxation of collateral eligibility. Banks bid for a larger-than-expected €489 billion, making it the largest-ever single refinancing operation in the ECB’s history. Further, 523 banks entered bids, as against 130 to 200 at the weekly MROs and roughly 180 at the previous 12-month LTRO.It is important to appreciate that the net injection of liquidity was far less than the headline number suggests.
Indeed, banks reduced their use of both the main MRO and the three-month LTRO, such that loans outstanding to euro zone banks via refinancing operations jumped by €175 billion to €835 billion after the provision of three-year funds or roughly half the amount reported under the three-year operation.
There is no doubt that the unconventional policy has eased funding pressures and prevented a liquidity crisis, but it is unclear whether the action will prevent a credit crunch since money market rates have far from normalised.
Additionally, banking systems in the periphery are almost entirely dependent on the ECB as a source of funds and are simply not in a position to expand credit. Further, the idea that additional funds garnered from these operations will make their way into stressed sovereign bond markets is hard to reconcile with the large refinancing demands the euro zone financing system faces through the remainder of the year – including roughly €250 billion of maturing senior unsecured bank bonds, more than €80 billion of government-guaranteed debt, and almost €20 billion of subordinated debt. The banking sector is likely to use much of the funds to meet these obligations as they fall due.
The financial markets await the ECB’s second three-year LTRO tomorrow. It may lead to continued improvement in bank funding markets but, alone, the policy is not sufficient to stabilise markets on a sustained basis. Investors should be aware that risk assets may well have discounted the good news already.
