Everything you wanted to know about the ECB's latest monetary policy (but were afraid to ask)

Once again, a great deal of confusion surrounds the European Central Bank's current policy objectives as well as the nearterm action expectations. Let's try to tackle the subject in a Q&A format.

Q:  Since the policy change announcement back in June, what has the ECB accomplished?
A:  In addition to lowering short-term rates, the ECB has launched the TLTRO program (4-year cheap loans to banks) and began its third covered bond buying program (these bonds are issued by banks and secured with loans).

Q:  What has been the impact of the ECB's interest rate reductions?
A:  The overnight benchmark rate has been set to near zero and the excess reserve rate has been moved to negative 20bp to incentivize banks to deploy capital. This has resulted in negative overnight interbank rate - banks pay each other to park their cash (which is still cheaper than parking cash with the ECB).

Overnight interbank rate in the euro area (source: emmi)

Furthermore, the euro's decline that resulted from negative rates and a possibility of further easing is expected to provide support for the export-dependent euro area nations.

Q:  Has the rate action resulted in more lending in the euro area?
A:  The immediate reaction of the area's banks to the negative deposit rate was to buy massive amounts of sovereign debt, including periphery bonds. This has resulted in unprecedented declines in government bond yields across the yield curve.

There is evidence however that credit conditions in the euro area are beginning to ease. Growth in broad money supply measures for example has improved markedly.

M3 YoY (source: ECB)

However, it remains unclear whether monetary policy had much to do with this development. Instead the banking system deleveraging cycle, which started a few years ago, is gradually ebbing. Moreover, the conclusion of the ECB's stress tests should help banks deploy more of their balance sheets in the private sector without the uncertainty surrounding the stress testing process hanging over them.

Q:  How much in TLTRO loans has been taken up by the banking system thus far?
A:  About €90bn - see story. This is well below some of the more conservative projections.

Q:  How much ABS (asset backed securities, such as credit card and auto loan receivables) and covered bonds has been purchased since the announcement of the program?
A:  The ECB has acquired a small amount of covered bonds but no ABS thus far - see schedule.

Q:  What has been the impact on the Eurosystem's (ECB's) balance sheet?
A:  The impact has actually been a net decline, as banks continue to repay their MRO and the original LTRO loans.

Eurosystem total balance sheet (source: ECB)

Q:  Why hasn't the ECB been able to buy more covered bonds and ABS in order to have a visible impact?
A:  According to Credit Suisse, the total amount of qualifying ABS and covered bonds the ECB could purchase is around €140bn. The volume is insufficient for the ECB to accumulate substantial amounts of paper without massively overpaying and disrupting this market. And even if the ECB did purchase that whole amount, it would take too long and have only a limited impact on the balance sheet expansion (note: this is roughly the amount of paper the Fed would buy in 2 months during QE3).

Q: There has been some talk of the ECB buying corporate bonds as well. Couldn't that help grow the balance sheet?
A:  Corporate bond purchases are a possibility, given the ECB can no longer afford to wait for the banking system to act as the area's policy transmission mechanism. According to Credit Suisse however, only about €100bn of corporate bonds would qualify/ be available for such a program. While it sounds like a large amount and would certainly cut borrowing costs for companies, the amount is insufficient to restore the Eurosystem's balance sheet to the 2012 levels.

Q:  How much then does the ECB need to expand its balance sheet in order to be credible?
A:  As discussed back in September, the ECB should probably grow the balance sheet by about €1 trillion. And the only way to achieve that is to augment existing programs with a more traditional QE effort that includes buying government bonds. Up to now there has been resistance from some Governing Council members (particularly) Germany, but supposedly Mario Draghi has been able to build consensus for such expansion - see story. That is why we had a rather sharp market reaction to the latest ECB press conference (see chart). Yet Draghi continues to downplay the €1 trillion balance sheet "target".

Credit Suisse: - ... ABS and covered bonds add up to €140bn-odd of potential purchases. Adding a (putative) €100bn of corporates is wildly insufficient to achieve the "target" [€1 trillion]. This target therefore has to be downgraded, in our view, to "something I believe I might have mentioned" while the much more thorny issue of "proper" (government) QE is addressed.

Q:  Why do many of the Governing Council members all of a sudden are convinced that such a drastic action (€1 trillion expansion) may be needed?
A: The persistently weak inflation readings have convinced them that Japan-style deflation risks in the Eurozone are quite real.

Source: ECB

Q:  When (if at all) will the ECB begin to purchase government bonds?
A:  The ECB is likely to wait on any traditional QE for some time, even though it has started to prepare for it (some ECB employees have been asked to dust off the old Securities Markets Program - SMP). The goal is to see if another round of TLTRO will meet with more demand and if inflation stabilizes on its own.

Q:  Will all this monetary activity by the ECB stem the declines in inflation?
A:  The technique used thus far has been to talk down the euro by hinting that a "bazooka" monetary event is on its way. That approach has worked. Whether the weaker euro will ultimately end up generating a higher sustainable inflation rate remains uncertain.

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TLTRO impact questioned as the carry trade provides easy money

The Eurozone banks' longer-term borrowings from the central banking system continue to decline, a trend that many economists view as a form of  "passive" tightening in the area's monetary conditions.

LTRO balance outstanding (source: ECB)

As discussed earlier (see post), the ECB will attempt to replace some €400bn of the lost balances with a new program dubbed TLTRO ("targeted" LTRO). Here is the official description:

The ECB: - Counterparties will be entitled to an initial TLTRO borrowing allowance (initial allowance) equal to 7% of the total amount of their loans to the euro area non-financial private sector, excluding loans to households for house purchase, outstanding on 30 April 2014. In two successive TLTROs to be conducted in September and December 2014, counterparties will be able to borrow an amount that cumulatively does not exceed this initial allowance.

During the period from March 2015 to June 2016, all counterparties will be able to borrow additional amounts in a series of TLTROs conducted quarterly. These additional amounts can cumulatively reach up to three times each counterparty’s net lending to the euro area non-financial private sector, excluding loans to households for house purchase, provided between 30 April 2014 and the respective allotment reference date in excess of a specified benchmark. The benchmark will be determined by taking into account each counterparty’s net lending to the euro area non-financial private sector, excluding loans to households for house purchase, recorded in the 12-month period up to 30 April 2014. All TLTROs will mature in September 2018.

The interest rate on the TLTROs will be fixed over the life of each operation at the rate on the Eurosystem’s main refinancing operations (MROs) prevailing at the time of take-up, plus a fixed spread of 10 basis points. Interest will be paid in arrears when the borrowing is repaid.

Starting 24 months after each TLTRO, counterparties will have the option to repay any part of the amounts they were allotted in that TLTRO at a six-monthly frequency.

Counterparties that have borrowed under the TLTROs and whose net lending to the euro area non-financial private sector, excluding loans to households for house purchase, in the period from 1 May 2014 to 30 April 2016 is below the benchmark will be required to pay back borrowings in September 2016.

The goal here is not just to pump up the Eurosystem's balance sheet, but, more importantly, to stem the relentless declines in corporate and household credit growth. The rationale for excluding mortgages apparently stems from fears of igniting another property bubble.

The portion in blue is particularly important. The ECB is "waiving a carrot" in front of the banking system: "do more lending over the next year and we will reward you with cheap funding."

Some argue that the TLTRO offering is useless because there is no demand for credit in the euro area. That's simply not true. The private sector credit supply/demand imbalance has widened significantly over the past year. Given the tepid growth in the Eurozone, the availability of credit is vital to maintaining the recovery. The ECB has finally given up on the notion of "creditless expansion" (see post).

Source: Credit Suisse

The biggest hurtle for the TLTRO program is the banks' unwillingness to grow private credit. The area's banks' ability to borrow based on their "loans to the euro area non-financial private sector" does not mean that they plow the new funds into the private sector. In fact analysts expect banks to borrow at 0.25% fixed for 4 years from the central bank and use a good portion of the proceeds to buy government paper that yields significantly more. Even at 0.37%, Spanish 1-year notes would be profitable for banks as a "carry trade".

Spanish 1-y government bond yield (source: Investing.com)

Part of the reason for this concern is the constant pressure to deleverage and tougher capital requirements under the new Basel rules. Short-term sovereign paper meets both, the minimal additional capital requirements as well as the liquidity criteria that banks are looking for. Why bother with personnel-heavy loan underwriting, high capital charges and illiquidity when there is easy money to be made. Government paper is in effect crowding out private credit.

Reuters: - Many analysts believe that, while bonds yields have narrowed substantially since the last LTRO, there is still an appealing carry compared with the 0.25% the ECB is charging for the funds. Sovereign debt carry trades will be doubly appealing because banks do not have to hold additional capital against such positions - but do against corporate bonds, loans to businesses and other assets.

"Carry trade yields have come down, but there is still money to be made," said Jon Peace, a bank analyst at Nomura. "With the zero risk-weighting on sovereign bonds, the carry trade will continue to appeal."

The carry trade will make the banking system the largest beneficiary of this program - as was the case in the previous 3-year LTRO offering. European bank shares are up some 60% over the past couple of years. Yet over the same period, private sector loans outstanding have been steadily declining. Some point to this program as being another example of central banks helping bank shareholders and irresponsible governments without significant benefits to the overall economy.

The argument from the ECB would be that only banks with large loan portfolios will be "rewarded" with this cheap financing, providing some level of incentives (particularly compared to the previous LTRO program). Furthermore, the improved bank profitability resulting from TLTRO is expected to help with the deleveraging process, which should result in a stronger banking system.

However, with all the easy money to be made in government bonds, the impact of the program on private sector credit expansion remains unknown.
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A look at today's ECB action - without the hype

In cutting through some of the media noise on today's action form the ECB, here are a few points worth discussing.

1. The negative rate on deposits would have been far more effective a couple of years ago when the Eurozone banks' excess reserves were a multiple of what they are now.

2. The end of sterilization of the SMP portfolio, bonds that the ECB had purchased a few years back (see discussion from Feb), will provide a boost to excess reserves. The current SMP balance is about €165bn - which is material relative to current excess reserve levels. Additional excess reserves will make the negative rate policy more effective.

3. The negative rate on deposits is sending banks into short-term periphery paper, as yields compress further.

Spain's 1y government bond yield (source: Investing.com)

It's important to note that excess reserves are a bit like a hot potato - you can pass them from bank to bank, but at the end of the day someone always gets stuck with them. That means some euro area banks will be making payments to the ECB of 0.1% on deposits. The Germans were quite upset about this - they feel that as far as their country is concerned the action will do more harm than good (see story).

4. The cut in ECB's main financing rate is basically symbolic. The problem with this near-zero rate is that if the ECB could set a separate rate for Germany vs. the rest of the member states, these rates would have been dramatically different. The so-called Taylor Rule, which models the "appropriate" interest rate, produces the following result.

Source: CIBC

This high discrepancy maintains tight conditions in "EZ ex-Germany", while risking asset bubbles in Germany due to a highly accommodate policy there. Here is an example.

Germany; Residential property prices, New and existing dwellings; Residential property in good & poor condition; Whole country (source: ECB)

5. The targeted approach to providing liquidity, the so-called TLTRO (€400bn), is a good idea.

Bloomberg: - Financial institutions will be allowed to borrow money from the ECB equivalent to as much as 7 percent of their outstanding loans to non-financial corporations and households, excluding mortgages.

The maturity will be up to four years, priced at the ECB’s benchmark rate when the loans are taken out plus 0.1 percentage point. Banks that don’t pass the money on will be obliged to repay it after two years. The so-called targeted longer-term refinancing operations, or TLTROs, will be carried out in September and December.

From March 2015 to June 2016, on a quarterly basis, banks will be able to borrow as much as three times the amount of their net lending to euro-area companies, above a threshold set by the ECB.

This creates incentives for banks to grow their "real economy" loan books. One of the problems with the Fed's QE program has been the weakening of loan growth (see post). Large firms and mortgage holders, who were able to refinance, certainly benefited from QE, but some of the biggest beneficiaries were asset management firms. That's why a targeted approach could prove to have more "bang for the buck"...

6. The ABS buying program is still in the works. There isn't sufficient amount of paper out there to have a large impact (see post), but we'll see what the central bank cooks up. They certainly have been quite creative.

7. Markets cheered, but the impact varied by asset class. The currency markets for example had a great deal of this ECB action already priced in  - and then some. The euro fell sharply on the announcements and then rebounded to finish up on the day.

Source: Investing.com

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From our sponsor:

5 reasons the ECB will act in the months ahead

It may be something symbolic such as a small rate cut or possibly a more substantial move such as a new LTRO program (discussed here), but the European Central Bank will be forced to loosen monetary policy in the near future.  Here are the reasons:

1. Liquidity:  The ECB's (technically the consolidated Eurosystem's) balance sheet is stll declining - down 28% since the middle of 2012. Excess reserves of the euro area banks are down nearly 80% over that period.

2. Credit:   Private lending in the euro area continues to fall - see chart.

3. Monetary aggregates:   Lack of loan growth has resulted in progressively weaker growth in the broad money supply. Most recent M3 print came in significantly below expectations - see chart.

4. Disinflation:  The euro area's price index growth is at the lowest level since the Great Recession and significantly below the ECB's target. Moreover, the growth rate seems to be deteriorating.

Furthermore, this disinflationary trend is not limited to the Eurozone periphery nations. Even Germany is showing signs of a slowdown in its inflation rate.

The last time Mario Draghi spoke on the topic, he hinted that this extraordinarily low inflation rate is an aberration. But that explanation is starting to get old. 

5. Emerging markets mess: While the ECB officials are denying that EM contagion will spread to the Eurozone (see story), the recent selloff in European equities says otherwise. Knock-on effects are inevitable, given the vulnerability of the Eurozone's recovery combined with the area's significant exports to emerging market nations.

Aside from these 5 reasons, the short term rate markets are now reflecting a policy change by the ECB, though the timing remains unclear. The June Euribor futures have spiked - indicating a lower implied Euribor rate -

Source: Eurex

... and German short-term government yields fell materially. These are signs of the markets' expectation of lower short-term rates going forward.

Over the next few meetings we should see a shift by the ECB toward a looser monetary policy. Otherwise the central bank will be toying with deflation risks.

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So far the ECB is not responding to ultra-low inflation readings

The Euro area inflation indicators are pushing into dangerous territory. The core CPI measure in particular is trending sharply lower. The ECB has so far been taking a "wait and see" attitude, though some on the Governing Council are apparently getting concerned.

Chicago Tribune: - Core inflation, which strips out volatile costs like food and energy, hit a record low of 0.7 percent.

The readout will heighten concerns at the ECB about entrenched price weakness taking hold, though strong company activity towards the of last year will give them some comfort.

"Obviously they are worried, but it's not significantly lower than it was a month earlier," Anders Svendsen at Nordea said. "I don't think it's enough to prompt a new rate cut but I do think it's enough to keep them dovish and ready to act."

Of course it's no longer about lowering the overnight rate. Given the persistent credit contraction in the euro area (see post), there is pressure on the ECB to add liquidity to the banking system by potentially providing another round of LTRO financing. The current LTRO balances are nearly half what they were after the last 3-year financing program was offered in 2012 (see story).

€ million  (source: ECB)

But many analysts believe the ECB will be on hold for some time because of seeming economic improvements in the Eurozone periphery (see chart below) as well as stronger data out of the US.

Source: Markit

There is some concern, paticularly in Germany that if the ECB's policies diverge from the Fed's, the euro could weaken significantly - potentially causing prices to rise more than desired. Germany's traditional fear of inflation and unease with unconventional tools seem to have permeated the ECB's thinking (particularly now with Ilmars Rimsevics joining the Governing Council). Doing nothing however is also a risky policy because ultra-low inflation and weak credit conditions are a recipe for Japan-style deflationary trap (see story).

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Euro area's persistent credit contraction

In spite of a number of positive economic indicators out of the Eurozone (see example), credit growth remains the area's Achilles' heel. The latest private sector loan growth aggregate from the ECB shows an annual decline of 1.8% (adjusted for sales and securitization - see press release). Here is what it looks like for the area's households and corporations.

Source: ECB

As a result the broad money supply growth has weakened as well, now well below long-term historical averages.

Euro area M3 aggregate (source: ECB)

Related to this weakness in credit growth, the area's disinflationary pressures do not seem to be abating, with the latest CPI aggregate below 1%. In Spain for example consumer prices have been basically flat for the past two years.

Euro area CPI (source: ECB)

With credit contraction remaining one of the key risks to the fragile economic expansion and inflation running below 1%, many economists are calling for the ECB to take further action (discussed here).

ISI Research: - Eurozone growth is still very slow, and inflation is MIA, so nominal GDP growth is minuscule. ECB could and should do more.

But given the historical lack of urgency at the ECB (particularly with the usual resistance from the Bundesbank), it may take some time for the central bank to "adjust" its policy.

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ECB contemplating new LTRO - with a twist

As discussed back in September (see post), the ECB may be forced to take further action in an attempt to reignite the area's recovery. The central bank's consolidated balance sheet is continuing to decline and many are blaming this reduced liquidity for the area's weak credit growth as well as tepid and uneven economic expansion.

It was therefore not too surprising to hear that the ECB is in fact discussing taking further non-conventional policy measures.

Reuters: - The European Central Bank is considering a new long-term liquidity operation available only to banks that agree to use the funding to lend to businesses, a German newspaper reported on Wednesday, citing sources.

ECB President Mario Draghi and other Governing Council members have repeatedly mentioned the option of conducting more liquidity operations, or LTROs, to help the fragile euro zone economy and ensure the flow of credit to the private sector.

A few months ago some economists were hoping that the relentless decline in credit growth in the Eurozone may have bottomed. The year-over-year changes in the area's loan balances have turned in the right direction. Unfortunately the latest data show that not to be the case - both in corporate and consumer lending.

Source: ECB

This lack of credit expansion is a dangerous trend that could result in years of Japan-style stagnation. In order to address it, one approach the ECB is contemplating is forcing the banking system to use the new LTRO proceeds to provide capital into the consumer or corporate sector.

Reuters: - The ECB extended more than one trillion euros ($1.36 trillion) of cheap three-year loans to banks through two long-term refinancing operations in late 2011 and early 2012.

But this time, an option under consideration is that the banks would have access to funding via the LTRO only if they agree to pass on the money in loans to industrial, retail and services businesses, Sueddeutsche Zeitung reported on Wednesday.

The new LTRO could also run for only nine or 12 months, the paper said.

The news came after ECB policymakers said last week they were open to taking fresh measures to support the euro zone economy, where inflation is running well below target [see discussion].

It's difficult to know if this program will work. Banks are under pressure to shrink risk weighted assets to comply with the new Basel accord. And retail and corporate (particularly unrated smaller firms) loans tend to attract significant amounts of regulatory capital (risk weight) charges. It's much easier for a Eurozone periphery bank to buy its government's bonds - with almost no regulatory capital impact - than to lend to small firms and households. Therefore many banks may forgo the new LTRO that has such strings attached. Nevertheless it seems that the ECB may be willing to try.

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Goldman: LTRO-III is only a matter of time

Over the past year, the ECB's (Eurosystem's) consolidated balance sheet declined roughly three quarters of a trillion euros. As discussed earlier (see post) most of this decline is due to the repayment of a portion of the MRO/LTRO loans that the ECB extended to the area's banks in 2011 and 2012.

ECB's (Eurosystem) balance sheet (source: ECB)

Some economists  - particularly those looking at the Fed and the BOJ - view this reduction as a form of tightening in the area's monetary conditions. The ongoing need to roll a number of maturing periphery governments' and banks' bonds, risks flaring up the debt crisis. Many believe the ECB should flood the banking system with liquidity once again in order to blunt any roll issues as well as to halt the declines in credit growth (see post).

A number of economists think that "LTRO-III", a third major long-term lending program to the euro area's banks, will help the situation. According to them it is only a matter of time before the ECB decides to proceed with another round of liquidity injections.

Goldman: - We no longer expect the ECB to offer a longer-maturity LTRO by the end of the year, following the latest statements from a number of Governing Council members to the effect that such a move was not being considered at this point. However, we maintain our view that such a measure would address several potential problems affecting the banking sector and the wider economy. A longer-maturity LTRO would, for example, buy insurance against the risk that maturing short-term government and bank debt would lead to renewed tensions in the Euro area financial system. We therefore continue to believe the ECB will eventually counter the decline in excess liquidity by offering another longer-maturity LTRO.

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Eurozone's falling excess reserves - is another round of LTRO required?

The euro area banking system excess reserves are continuing to decline - touching the lowest level since 2011.

Just to put this in perspective, the chart below shows excess reserves in the US. With the Fed continuing to pump liquidity into the system, these swelled above $2.3 trillion last week - a new record.

The reason the Eurozone reserves are declining has to do with the area's banks gradually repaying what they have borrowed from the Eurosystem via MRO and LTRO loans.

Source: ECB

Some economists view this decline in excess reserves as an indication of tighter monetary conditions in the Eurozone. They point to weak consumer credit growth and a severe contraction in corporate lending.

YoY change in loans to euro area households (source: ECB)

YoY change in loans to euro area companies (source: ECB)

A few economists have called for Mario Draghi to offer up another round of LTRO lending or lower the rates on MRO (short-term) loans in order to boost excess reserves. The thought is for the ECB to follow the Fed's and the BOJ's lead at the October meeting and expand its balance sheet.

Such action however is unlikely at the next meeting. Certainly if these declining excess reserves push up rates, the ECB will have to act. But the central bank does not have the Fed's dual mandate and is not as focused on the Eurozone's dangerously high unemployment levels. Instead Draghi will concentrate on forward guidance of maintaining low overnight rates for the foreseeable future. The ECB will want to keep the LTRO tool in its back-pocket in case the crisis flares up again. After all, there is a nonzero risk of the German Constitutional Court ruling against the OMT program (ECB's commitment to directly purchase government bonds of periphery nations). Other issues, such as political uncertainty in Italy (see post), could potentially reignite the crisis as well.

For now Draghi will want to see if the Eurozone's credit markets can begin to "heal" themselves. The members of the Governing Council are following a number of business surveys which seem to point to stabilization in the area periphery nations.

Source: Econoday

If however lending volumes do not show a visible improvement in the next few months, another LTRO program could be in the works at a later date.

Bloomberg: - Frederik Ducrozet, an economist at Credit Agricole CIB in Paris says an LTRO is unlikely until December. The central bank could boost its forward guidance by putting a definite end date for loans at a particular cost, by issuing an LTRO with a fixed rate, he said. The previous loans were charged at the average of the ECB benchmark over the maturity.

‘‘A properly-designed LTRO would have the potential to kill several birds with one stone by enhancing forward guidance, keeping excess liquidity higher for longer, and further boosting the use of collateral from small businesses,’’ Ducrozet said.

ECB officials including Executive Board member Benoit Coeure have played down the short-term likelihood of a new round of long-term loans, saying that while it remained an option, it hasn’t been specifically discussed. The ECB’s Governing Council convenes in Paris on Oct. 2 for its monthly rate-setting meeting.

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Massive decline in euro area's excess reserves is not an indication of improved lending

The decline in euro area banks' excess reserves has been quite spectacular. Excess reserve levels are back to 2011 levels.

Source: ECB

Some are attributing this to banks "no longer hoarding cash" and therefore lending. That's nonsense. This decline in excess reserves was a direct result of banks reducing their borrowing from the Eurosystem. The combination of the MRO, the LTRO, and the MLF loans from the ECB has been falling.

Source: ECB

Why are banks paying off their loans? Some have found alternative sources of funding in the private markets (repo or secured bonds for example), but a great number of Eurozone banks are simply deleveraging. As they reduce their assets, they don't need to borrow as much. Sadly, this deleveraging has resulted in extraordinarily weak loan growth, both to households,

YoY growth in loans to Eurozone households (source: ECB)

... and to corporations.

YoY growth in loans to Eurozone non-financial companies (source: ECB)

While there are some signs of economic improvements in certain parts of the Eurozone, the deleveraging of the banking system and nonexistent loan growth does not bode well for a near-term recovery.

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Markets may ease the expected "collateral scarcity" problem

In the past couple of years we've seen a great deal of focus on the so-called "collateral scarcity" problem. The new regulatory regime is expected to create incremental demand for high quality collateral such as treasuries, Bunds, etc. This increase will come from Basel III liquidity rules for banks and new derivatives regulation as it pertains to margin requirements. Some of the new regulations combined with central bank activities are also expected to limit the supply.

What makes tracking collateral tricky is that securities such as treasuries are often lent out multiple times. If someone posts treasuries as collateral on a loan, the collateral holder will generally have the ability to use these same securities as collateral for another loan from someone else and so on. That chain acts to provide collateral movement through the financial system to facilitate secured lending such as repo. And given the recent move toward secured lending (see post), access to quality collateral is paramount.

As the attached paper discusses, there is going to be plenty of quality collateral supply in the coming years with governments pushing out more debt into the markets.

Source: Banque de France • Financial Stability Review

The concern centers around what happens to this new supply. According to some estimates, 60-70% of the supply ends up in “non-lendable” accounts. These accounts do not permit lending of securities into the market, restricting the amount of collateral in circulation. Furthermore the new derivatives regulation is expected to force the use of "segregated accounts" - where collateral posted on derivatives positions will no longer be allowed to be lent out ("re-hypothecated"). That is expected to put a further strain on the availability of liquid collateral.

Another reason many are concerned about collateral availability has to do with central banks. The ECB accepts quality collateral for loans it provides to Eurozone banks (MRO and LTRO). That collateral has effectively been "trapped" in the Eurosystem and can not be lent out. Similarly the Fed and the BOE trap collateral through their securities purchase programs.

So far, the collateral scarcity issue has been limited to banks in the Eurozone periphery and mostly during periods of interbank credit crunch. The euro area as a whole, for example, has not experienced a problem with collateral availability.

Reuters: - Some economists have expressed concerns that a shortage of collateral could have a negative effect on bank lending, but ECB policymakers have said in the past that tighter collateral conditions tend to exist only in parts of the bloc struggling most with the debt crisis.

On average, banks had put forward 2.448 trillion euros in 2012 as collateral at the ECB, up from 1.824 trillion euros the year before. The average amount of the use of the ECB's lending facilities was 1.131 trillion euros in 2012.

"The level of over-collateralisation shows that, at the aggregate level, the Eurosystem's counterparties experienced no shortage of collateral," the ECB said in its annual report.

But what about collateral issues going forward? The various forecasts indicate that collateral shortages will be triggered by impending new regulation. That is definitely a risk, but part of the problem with the forecasts on collateral shortage is that they tend to make static assumptions. Here is an example. An Italian bank that owns quality collateral may have had little choice in late 2011 but to use its quality bonds as collateral with the Eurosystem for an LTRO loan. But as demand for such collateral increases, that Italian bank may be able to use the same bonds as collateral for a loan from another EU bank on better terms. Paying 1% to the ECB, as cheap as that sounds, may be more expensive than doing a repo with a bank that really needs that collateral.

While temporary collateral shortages may exist, over time the market will "unlock" more of it. Portfolios that normally don't lend out quality bonds (such as some pensions) will be able to generate extra revenue - especially in this low rate environment - by adjusting their policies. All of a sudden a much larger pool of bonds may become available, driven by higher demand. Between market pressures to unlock collateral and governments more than ready to borrow - now that austerity is out of fashion - collateral scarcity may not be as big of an issue as some have predicted.

Barclays: - ... these are static analyses that do not account for changes in the behavior of investors. Indeed, if the supply of high-quality assets gets scarce relative to demand, the resulting price increase is likely to pull more safe assets out of non-lending custody accounts. Similarly, to the extent that there is balance sheet availability, banks may step in to transform weaker collateral into the high-quality liquid assets required to settle initial margin – for a fee.

Collateral scarcity and asset encumbrance

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From our sponsor:

Trends behind declining LTRO balances; Italy overtakes Spain as the largest LTRO borrower

As European banks find some private sources of capital to fund themselves, they continue to repay their ECB loans - particularly in the 3y LTRO program.

FoxBusiness: - Next week, nine banks will repay just over 4 billion euros ... in loans during the first round of three-year financing in late 2011, ECB data showed Friday. Eleven banks will repay just under EUR4 billion of the second borrowing spree in early 2012. Total repayment is just over EUR 1 billion more than was repaid this week.

LTRO balances in the Eurosystem (unit = €1mil; source: ECB)

Part of this repayment trend however is coming from over-borrowing in early 2012. As banks, particularly in Spain saw their deposits dwindle, they went into a panic mode, borrowing all they possibly could - particularly with Spain's government "encouraging" them to buy government paper. But as portions of the deposits came back (see post) and banks being able to sell some government paper (thanks to the ECB's commitment to buy it), they are repaying some central bank borrowings.

One of the issues Eurozone banks are facing is that they simply can't grow their assets - in fact balance sheets are shrinking. Due to tougher regulatory capital environment as well as general fear of extending credit, lending has been grinding to a halt. Loans to corporations have been declining steadily for some time.

Change in loan balances to companies year-over-year (source: ECB)

And loans to households are basically not growing.

Change in loan balances to households year-over-year (source: ECB)

With banks not willing to extend credit nor sit on cash, the only viable option is to repay some of the liabilities - hence the decline in LTRO balances.

Of course the repayment of LTRO has been uneven across the Eurozone.

Source: Credit Suisse

Spain, having been the largest borrower, also had the largest (in absolute terms) reduction. Clearly most German banks don't need this funding, given the growth in the nation's deposit base. Italy on the other hand remains a problem. In fact Italy is now the largest borrower from the Eurosystem, as Spain dropped to second place. Given the devastating recession and the political uncertainty Italy is facing, LTRO balances of Italian banks will be critical to watch going forward.

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Spain's banking system bleeding contained for now

Spain's banking system continues to struggle, with Bankia reporting more losses and tapping the government's bailout vehicle.

The Guardian: - Spain's answer to RBS – Bankia – published the worst results ever seen by a Spanish corporation, racking up 2012 losses of €19.2 bn (£16.6bn) as the nationalised bank drowned in a sea of toxic real estate left over from the country's burst housing bubble.

The figures confirmed the dire fortunes of a bank formed out of a merger of seven of Spain's ailing savings banks in 2010 as the government made a futile attempt to save them from disaster. Client flight during 2012 helped bring a 13% fall in total deposits.

Bankia became the focus of Spain's banking crisis last year after auditors refused to sign off on the accounts presented by company president Rodrigo Rato, a former finance minister from prime minister Mariano Rajoy's People's party (PP) and one-time head of the International Monetary Fund. It is now taking €18bn in bailout funds from the country's Frob bank restructuring fund, which had to borrow the money from the eurozone's bailout fund as part of a €40bn rescue of several struggling banks.

2012 has been particularly difficult for Spanish banks who relied on domestic deposits. Panicked depositors moved cash to Germany or even out of the Eurozone altogether to Switzerland. That forced the banks to tap the ECB's long and short-term lending programs for most of their funding needs.

But there may be some good news on the horizon. Some deposits are returning to Spain - cash flows recently turned positive. The flow data has a great deal of noise due to the effects of recent tax deposits as well as the issuance of commercial paper (pagares). The adjustment for pagares is shown below.

Source: Credit Suisse

Whatever the case, the "run on banks" taking place in Spain a year ago seems to have stopped - for now. That in turn slightly reduced banks' reliance on the ECB, particularly in the short-term funding program (MRO).

And as discussed before (see post), this reversal of flows should reduce Spain's TARGET2 liability - which is exactly what happened.

Clearly, both of these measures are highly elevated relative to historical levels, but nevertheless the "bleeding" has been contained.

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Negative rates on deposits would force Eurozone core banks to repay their LTRO funding

There is concern among some Eurozone banks that the ECB may push the deposit rates on excess reserves into negative territory next year. In fact the 12-month EUR OIS rate (the so-called EONIA swap rate), which is the market expectation of where the overnight rates will be next year, briefly dipped below zero recently.

Source: euribor-ebf

If that were to happen, banks would in effect be penalized for holding excess reserves at the ECB. Such action would force those who are able (more likely the core banks) to pay down their borrowings from the ECB (otherwise they are paying 1% for the LTRO funding and then paying again for depositing the cash at the ECB).

JPMorgan: - There has been renewed speculation that the ECB will set a negative rate on its deposit facility. Indeed, the EONIA curve, which tracks the deposit facility, dipped into negative territory for the first time last week. Negative interest rates on deposits are like safe deposit charges – the idea is that they should incentivize banks to lend out money rather than suffer an erosion of capital.
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Core banks are more susceptible to negative deposit rates. The first response by core banks would be to repay back most of the extra funds they borrowed via the 3y LTROs, which they can do from January 30th. We previously argued that core banks could repay €100bn of 3y LTRO funds as yield compression makes carry trades less attractive. But an ECB deposit rate cut to -25bp could induce them to pay back perhaps all of the €140bn they borrowed on net via the 3y LTROs.

In preparation for this potential event, banks have been paying down the shorter term LTRO balances (not all LTRO is 3 years). In fact the ECB is showing a gradual but consistent decline in LTRO funding provided to the euro area banks.

LTRO funding by the Eurosystem to MFIs

According to JPMorgan, the effect of a negative deposit rate on excess balances would help the Eurozone periphery by pushing capital out of the core.

JPMorgan: - ... an ECB rate cut to -25bp could accelerate that process [of paying down LTRO]. In trying to avoid negative carry, the resulting search for yield and increase in the velocity of reserves, i.e. passing on the “hot potato”, within the euro area banking system is likely to improve capital flows back to peripheral banks and reduce TARGET2 imbalances, especially now that the ECB has back-stopped the system with OMT. From this perspective, negative deposit rates could be a useful policy tool to induce financial re-integration in the Euro zone and ultimately allow the periphery to reduce its reliance on the ECB.

Of course one of the reasons the Fed hasn't followed this path is a potential disruption to the money markets. Even the recent drop to zero rate on deposits by the ECB has caused havoc for euro denominated money market funds (see discussion). A negative rate would force money market firms to simply kick the existing depositors out, forcing them into periphery government paper or periphery banks - which of course is the idea behind negative rates.

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