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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From our sponsor:

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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From our sponsor:

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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From our sponsor:

ECB rate cut impact will be marginal at best

The markets were not impressed by today's policy announcement from the ECB. Sovereign spreads are wider, the euro is lower by 1.1%, and European stocks are down 1.2% on the day. Here is what the ECB's Governing Council had decided:

ECB:

1. The interest rate on the main refinancing operations [MRO] of the Eurosystem will be decreased by 25 basis points to 0.75%, starting from the operation to be settled on 11 July 2012.

2. The interest rate on the marginal lending facility will be decreased by 25 basis points to 1.50%, with effect from 11 July 2012.

3. The interest rate on the deposit facility will be decreased by 25 basis points to 0.00%, with effect from 11 July 2012.

What does this mean for financial institutions and the ECB's attampt to ease credit conditions across the Eurozone?

1. About €180bn is currently borrowed under the MRO, and the rate cut should provide some relief for periphery banks who are the primary users of the facility. But the cut translates into savings of about €37.5 million euros a month - for all the banks using the facility combined. This is clearly helpful but is going to make little difference in these banks' behavior (in terms of credit) because they are looking for liquidity relief, not a tiny reduction in their borrowing costs.

2. Only €0.7bn is borrowed under the marginal lending facility. That's less than €150 thousand a month in savings - not even worth discussing.

3. Setting the deposit rate to zero (something the Fed had also considered) will have an impact on German and other stronger Eurozone institutions who have a great deal of excess liquidity. Thus far these banks have been moving funds between the reserve accounts and the deposit facility. That's because they need to maintain a minimum average balance in the reserve account (which pays zero interest on excess reserves). Once they achieve that average for the month (by holding an excess amount over a few days) they would move the funds back into the deposit facility which paid them 25bp.

ECB Deposit Facility (€MM)

Now with the reserve account and the Deposit Facility both paying zero on excess reserves, they will simply leave the money in the reserve account. Other than this change, banks' behavior is not driven by what they receive on excess reserves and whether the reserves sit in the Deposit Facility or the reserve account. It is highly unlikely therefore that the difference between 25bp and zero on deposits at the ECB will somehow encourage these stronger banks to extend more credit.

The markets were hoping for more action from the ECB on the heels of the recent summit. The hope was that if the politicians make a move in the "right direction", the ECB will reward them with more "non-standard monetary policy measures". But Draghi thought otherwise and of course the markets reacted accordingly.


For further discussion on the ECB rate cut see this post by Kostas Kalevras.

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ECB's balance sheet hits €3.1 trillion; nearly half the assets are loans to banks

The ECB continues its relentless march of balance sheet expansion. For the first time the total assets of the Eurosystem have exceeded €3.1 trillion.

€ MM

Jean-Claude Trichet used to argue that unlike the Fed's balance sheet during 2008-09 period, the Eurosystem assets were dominated by securities, gold, and foreign reserves, rather than loans to banks. That composition is changing quickly however. Here it the ECB's balance sheet assets breakdown from a year ago - with circled items representing lending to Eurozone's banking institutions under various programs.

 

And here is the current balance sheet asset breakdown. Lending to banks went from under a quarter of the balance sheet to close to half (47%) in a year. Trichet would have a tough time makeing the same statement today.

And this expansion shows no sign of abating as loans to Eurozone's financial institutions continue to grow, rapidly approaching one and a half trillion euros.

€ MM

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MRO - LTRO relationship

Some have asked to see a longer period chart of the MRO (main lending facility) balances at the ECB. Here is the chart from the beginning of 2010 comparing MRO and LTRO. Keep in mind that the LTRO program existed before Draghi took over the ECB. The difference is that the program in the past was mostly 3 months in maturity rather that the 3-year loans that Draghi introduced. Note that maturities/reductions in LTRO generally corresponded with increases in the MRO balances. And of course the recent LTRO loans reduced MRO balances to almost zero - until recently.

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Time for LTRO-III?

In his weekly update on the ECB balance sheet, Kostas points out (among other developments) an increase in lending to banks (now at €1.24 trillion - a new record). Much of the increase comes form MRO - the ECB's main lending program. The bulk of these new loans likely represent the replacement of lost deposits at Spanish (and other periphery) banks as run on the banking system there continues.

The first LTRO funding was put in place shortly after Mario Draghi became the head of the ECB. MRO levels were quite high at the time. The 3-year LTRO programs Draghi put in place drove down MRO balances dramatically as banks rolled their short-term financing (MRO) into the long-term LTRO.

Since the last LTRO funding however, the MRO amount has risen significantly, particularly in the past few weeks. It is now above the level it was prior to the last LTRO, indicating a sharp increase in demand for liquidity. That may be a signal for the ECB that it is time for a third round of LTRO in order to ease the tight liquidity conditions.

MRO balance

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ECB lending by country

Here is a nice chart from Barclays that shows how much the various nations' banking systems rely on ECB funding. The data is as of the end of May except for three countries.

Source: Barclays Capital

The bulk of this is via LTRO (3-year) loans. Spain's banks however also tapped MRO (short-term) loans in May because the 3-year LTRO is not currently available and banks had to shift funding from private sources (deposits) to the central bank. Given that all of these loans are collateralized, some have asked where do banks get this seemingly unlimited amounts of collateral. The answer is that once banks run out of assets that are "ECB eligible", they create new collateral with the help of their governments (as discussed here and here).

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Spike in ECB's MRO facility

Yesterday Kostas Kalevras pointed out a big spike in the ECB's MRO (main refinancing operations) facility. MRO is the central bank's short-term lending facility. Back in February when the ECB offered out the second 3-year LTRO, banks rolled a great deal of their short term MRO loans into the 3-year facility. But something occurred in the last few days causing a €68bn increase in MRO (more than doubling the outstanding balance).

ECB's MRO facility (€bn)

One possibility - and this is pure conjecture - is that this is incremental support for Spanish banks. If the Spanish government guaranteed newly issued bank bonds, such bonds could be posted as collateral at the ECB. That would allow Spanish banks to draw on the MRO facility and purchase newly issued as well as secondary government paper (see this post on how this has been accomplished in the past). That could explain the run-up in Spanish bonds over the past few days as well as the successful auction this morning.

NY Times: - Spain carried out a successful bond auction Thursday under intense scrutiny, even as expectations are growing that Madrid will soon ask other European nations to bail out its banking sector.

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Restructuring the Irish promissory notes

In 2010 the Irish government bailed out (recapitalized) the Irish banks with 30bn euros. The government could not easily raise these funds in the market so it used promissory notes (PNs) instead of cash (sort of what California did when they paid salaries with IOUs during their "budget issues" in 09). These PNs are set up to pay a set amount over the next 20 years.

The promissory notes were used as collateral with the Central Bank of Ireland to obtain central bank emergency financing called ELA. That collateral did not qualify for LTRO, leaving ELA balances outstanding. Since then the banks were "restructured" creating the Irish Bank Resolution Corporation (IBRC) - the "bad bank" to hold all the wonderful real estate loans and properties. Now IBRC owes the Central Bank of Ireland money under the ELA.

This year about EUR 3.1bn of PNs was due (on March 31st), but the Irish government was in no position to pay that in cash. Instead the goal has been to kick the can down the road - as far as it can roll. The Finance Minister Michael Noonan has been trying for a while to restructure the PNs by swapping them into long-term government bonds. His negotiations with the EU/ECB have yielded only a partial result. He was able to roll just the 3.1bn due this year, but it required a fairly messy transaction. The issue is that the ELA financing is meant to be a temporary measure and the ECB wants it paid down asap.

Here are the steps for the restructuring of the PN - just the EUR 3.1bn (this time around - no guarantee this will work next time):

1. The Government issues a long-term bond that it delivers to IBRC in return for IBRC extinguishing the 3.1bn worth of PNs (it effectively pays its "promise" with long term bonds instead of cash).

2. IBRC places the bond as collateral with the Bank of Ireland (not to be confused with the Central Bank of Ireland) to borrow cash for a year. Given that the Bank of Ireland is controlled by the government, it can roll this loan indefinitely.

3. IBRC uses the cash from the loan to pay down the ELA financing and get back the PN it had out with the Central Bank of Ireland.

4. The Bank of Ireland then uses these long-term bonds as collateral to borrow from the Central Bank of Ireland/Eurosystem under the MRO or 3m LTRO programs.

Restructuring of Irish promissory notes

With this transaction, the Irish government doesn't have to use cash to pay the promissory notes, the Bank of Ireland makes a spread between where it borrows from the central bank and what it receives from IBRC, and the ECB makes sure that the ELA is paid down. Everyone is happy, right? Not exactly. This is a difficult transaction and Michael Noonan would much rather have used financing from EFSF directly. Most importantly, this is only a portion of the PN restructuring and this issue will be back shortly when the next portion of the PN is due. In 2014 the PNs due will constitute some 15% of projected cash needs of the Irish government.

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