Saturday, March 3, 2012

The issue with LTRO-II is not the spike in Deposit Facility

The American Enterprise Institute blog has posted an article entitled "The chart that should terrify the ECB" by Daniel Hanson. It shows a massive spike in the ECB Deposit Facility.
The deposits, which pay interest at 0.25 percent, have largely been made with funds obtained through two rounds of long-term refinancing operations, which charge an interest rate of 1 percent. Basically, banks are hoarding cash and losing money on the deal—something that will surely be a problem for the European economy.
Well, here is some news for Mr. Hanson and the American Enterprise Institute. The spike in the Deposit Facility was entirely expected. Even if every last euro from the 3-year LTRO facility was lent to Erozone citizens and corporations or used to buy securities, the Deposit Facility would still grow by the same amount. The rise in excess reserves, the bulk of which are balances in the Deposit Facility, simply represents net new lending by the ECB.

EUR MM, source: ECB

As discussed before, when the ECB lends money to a bank (via the National Central Banks), it simply credits the bank's reserve account. In the latest LTRO facility, about 2/5th went to repay short term loans from the ECB (rolling them into the 3-year loans). The other 3/5th became excess reserves. And banks just moved much of the excess reserves to the Deposit Facility because it pays a better rate than what they get in the reserve account. Some, possibly a big part of this liquidity will be used to repay bonds issued by banks during "good times" that are maturing in 2012 (many of these banks can not roll their maturing bonds - there are simply no private buyers).

The reason the spike in excess reserves is higher now than it was after the previous LTRO loan (chart above) is due to the fact that a smaller portion of the recent facility (LTRO-II) was used to repay existing short term loans. This generated larger net new borrowings from the ECB, thus higher excess reserves. At this stage the bulk of the borrowing from the central banks in the Eurozone is in the form of 3-year loans.

The mistake people often make is assuming that if banks were to lend these new euros out, the euros would leave the Deposit Facility. But any euro "created" by the ECB (via net new lending) has to end up in some bank's excess reserves (like the game of musical chairs). It may not be the same bank that took out the loan from the ECB, but it is still a bank within the Euro-system. So one way or another (whether banks, lend to each other, to clients, or buy securities) some bank in the Euro-system will end up with the excess reserves (net new euros never leave the system).

The issue with LTRO-II is therefore not the spike in the Deposit Facility. It is with the fact that Eurozone periphery (plus French and Belgian) banks end up using far more of the facility than banks from the "core" (particularly Germany). That has three effects:

1. It increases TARGET2 imbalances, with periphery central banks owing Bundesbank more money (as discussed here).

2. It creates a further imbalance in M3 money stock. Periphery banks use up the collateral previously employed for secured interbank borrowing (repo) to now post with the ECB against the LTRO loans. The collateral effectively leaves the system (and gets "trapped" at the periphery central banks for 3 years). A decline in repo borrowing among the banks in the periphery reduces broad money supply in these nations.

3. As more of the collateral, including retail and business loans (including ABS), that now qualifies for LTRO, is pledged to the ECB, any unsecured bonds that periphery banks still have outstanding will have zero recovery in case of default - since all the "good" assets have now been pledged (encumbered).
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