Money market fears point to more ECB bank loans

In late 2011, soon after he became president of the European Central Bank, Mario Draghi took drastic action to save the eurozone. He announced a wall of money, in the form of ultra-cheap loans, to prop up the region’s banks under the rubric of a “long term refinancing operation”.

The first deadline for paying back some €1tn in loans is over a year away. But that looming date is already making investors nervous. The rates at which banks lend and borrow to each other in European money markets have begun to rise.

Mr Draghi addressed those concerns last week, making it clear that the ECB could pump more cheap money into the financial system. Another LTRO could be used to prevent a “liquidity accident” derailing economic recovery in Europe.
These increases in money market rates might not sound much. But as banks pay back the cheap three-year ECB money – LTRO repayments increased from €137bn at the end of January to €352.9bn last Friday – they pose a threat. If sustained, the rise in money market rates could snuff out economic recovery in more vulnerable parts of the eurozone.One-week Euribor – a key measure of shorter term bank borrowing rates in the money market – has increased from 0.08 per cent in January to just below 0.1 per cent now; one-month Euribor has risen from 0.1 per cent to 0.128 per cent and three-month Euribor increased from 0.18 per cent to 0.22 per cent.

“It’s a potential safety net,” says Simon McGeary, managing director of capital markets at Citigroup, of another LTRO. “The ECB doesn’t want investors to be second guessing it at a macro level and knowing liquidity will continue to be made available makes sure concerns about that do not arise again.”

“I think further LTRO is needed and soon,” says Jens Larsen, chief European economist at RBC Capital Markets. “The auction should be in the first quarter of next year . . . there’s no point in waiting longer. The danger is that higher money market rates spills into expectations of tightening monetary policy in longer maturities.”

Making more cheap ECB loans available may sound like a sensible idea. But one problem with it is that banks could be stigmatised by accepting the money. Last time Mr Draghi helped persuade strong and weak banks alike to take the funds. Such a broad take-up is unlikely next time round.

“The first question everyone will ask is: are you on LTRO support?” says one senior eurozone banker. “They need to call it something else.”

An alternative option would be for the ECB to cut its refi rate, or the main interest rate banks can borrow money at. Morgan Stanley economists argue the ECB should reduce the refi rate by half to 0.25 per cent to offset anxiety about tightening money market conditions and a forthcoming review of banks’ assets.

The European Banking Authority, which is administering EU-wide bank stress tests next year, is still weighing the details of its exercise. In previous years, particular attention has focused on the level and quality of banks’ capital.

That will continue to be the case, especially for banks in countries where high loan losses threaten to burn through equity buffers. But this time an important – and potentially contentious – element of the EBA’s tests will centre on the robustness of banks’ funding and liquidity positions.

The EBA may penalise banks that are largely reliant on the LTRO. Unless the ECB extends the scheme, the EBA test looks set to give LTRO-reliant banks a low mark.

Some argue that concern about higher bank lending rates is overblown. Instead of providing fresh loans the ECB could instead extend the maturity of existing LTRO loans to those banks who need more time to repair their balance sheets.

“I don’t see the point in more LTRO,” says Anders Svendsen, chief banking analyst at Nordea. “What we’re talking about is a drop in excess liquidity, not liquidity itself, and what drives this is repayment of LTRO which banks decide themselves.”

“It was expected from the beginning that there would be a number of banks, for example in Spain and Italy, who would need liquidity support for a very long time.”

Others say the bigger issue is capital, with troubled banks not generating enough earnings to be viable. That in turns generates questions over their liquidity, or their ability to turn assets into cash, locking those banks out of money market funding. Hence the “cliff” in investors’ sights once the current LTRO ends.

“A capital problem becomes a liquidity problem when you can’t refinance yourself [in the market],” says Mr Larsen: “The orderly way to wind LTRO down is to have another one so we don’t create this cliff . . . yes, [we are replacing cliffs with cliffs] but it would be a much smaller cliff than last time.”