Educated Guesses on the Upcoming ECB Auction and Thoughts on some Crisis Legends… – Euro Thoughts Sep 13-18 2009

The September press conference and the following interventions by Trichet, Weber, Bini Smaghi and other Council members have definitely clarified that the ECB is in no rush at all to act on rates; rather it wants to have at hand more concrete evidence that the recovery is gaining momentum and price risks start moving to the upside before pondering to remove the current accommodative stance on rates.

Hence, the market focus is now all centered on the upcoming one-year long-term refinancing operation (LTRO) to be held on September 29. We all know that the previous LTRO on June 24 resulted in a record EUR 442 billion (circa 1.4% of total assets of euro area credit institutions) being allotted to the euro area banking system at the fixed rate of 1%. The result has been the creation of a large liquidity surplus in the system that, in ECB’s intentions, should provide enough ammunition for banks fearing liquidity risk. In turn, this should allow them to keep extending credit in favor of the real economy.

At the time of writing, the outstanding of ECB open market operations is around EUR 700bn (the peak being hit at EUR 896bn after the June LTRO). The recourse to the deposit facility of the ECB remains in the EUR 180bn area, thus confirming that it remains banks’ favorite liquidity buffer. In the August Bulletin, the ECB shows that the liquidity surplus – the difference between total outstanding liquidity and the actual liquidity needs (excess reserves + deposit facility + reserve requirements) – is just a tad below its June’s peak after that in the first half of this year it had almost disappeared. Summing up, banks are more than shielded from any liquidity shock that may occur over the next year, and remain under pressure to extend credit to the real economy provided that such large liquidity buffers should enhance their confidence.

We have been thinking a lot about the possible reasons of the June surprising outcome. We have come up with three motives that may explain the record operation.

1.     True funding needs of persistently-troubled banks. For a number of small and medium banks, funding sources remain scarce and dry, plus there may well be the case that some larger players are still experiencing difficulties in accessing to markets.

2.     Liquidity ratios. In some European countries, as far as liquidity ratios are concerned, there is not the typical equivalence between pure liquidity assets and government bonds. Hence, banks of these countries still have to prefer ECB funding to enjoy sounder ratios.

3.     Market conditions. We are faced with the steepest yield curve (on the 2-10 year spread) of the euro area history. Once the ECB decided to provide unlimited liquidity at the refinancing rate, the possibility that some banks took money from the central bank at 1% to invest it at longer much more profitable maturities cannot be excluded. At the timing of the June auction, asset swap spreads – for those banks not desiring a higher duration – were very attractive.

We suspect that the persistence of a very large liquidity surplus has to be ascribed not only to the first, but also to the last motive. A very steep yield curve from the 2-year maturity onwards is a key support for banks in tough times. Plus, it has also to be considered that for actual (binding) funding needs, a number of ECB facilities were already in place well before the June LTRO.

If one takes the current liquidity surplus (absent in June) as a starting point, then it’s relatively easy to guess that the amount allotted at the end of September should be lower.

a.     Severe liquidity needs at different maturities should have been already fulfilled by the June LTRO.

b.    Liquidity ratios are usually computed over a 3- or 6-month horizon. Hence also reason 2) above shouldn’t apply.

c.     The investment motive should be, at least partially, weaker. Since the end of June, asset swap spreads have moderately tightened, less for the benchmark German curve but definitely more for peripheral ones. In a nutshell, there is less carry across the board to exploit.

For these reasons, we think that a EUR 125-175bn guess can be considered reasonable. Of course, surprises cannot be excluded at all, and forecasts like these have to be taken very cautiously. There remains a great deal of uncertainty as the ECB has stressed repeatedly. Be prepared for everything, also because a look at the latest figures on the difference between the maturing and the renewed amount on the previous shorter-term ECB refinancing operations indicates that banks are creating room on their balance sheets for the big event at the end of the month. At the date of September 9, the difference between matured and renewed was of EUR 112bn, excluding weekly MROs.

Trying to dismantle some myths…

Regardless of the amount of money that will be allotted on September 29, it is clear that the ECB is still guaranteeing intermediation of funds among banks, thus replacing, at least in part, the interbank market. However, as the acme of the crisis gets farther, it is possible to look at past things also with a different perspective and discover a few interesting things on some mantras that have accompanied us throughout these two hectic years.

In a special feature contained in the June Financial Stability Review (http://www.ecb.int/pub/fsr/shared/pdf/financialstabilityreview200906enspecialfeaturesB.pdf?1cd17818d7c607d026055911f546f61d), ECB scholars provide an interesting timeline of the crisis on the interbank market looking at the most recent literature. First, contrary to common readings so far, they demonstrate that the interbank market did not seize up in the first part of the crisis. Actually, the ECB shows that from an average EUR 40.9bn in the year to August 9 2007, the daily volume of transactions rose by 30% to EUR 52.1bn in the period between 9 August 2007 and 26 September 2008. Afterwards, the crunch materialized.

Another common belief has been that the market ceased to function ONLY (or chiefly) for a fundamental mistrust among players about their respective asset quality and risk exposure. As usual, reality is more complex. The same study cited above shows that the interbank market experienced the three classical regimes of unsecured markets with asymmetric information described by the recent literature. In the first regime (pre-crisis), despite asymmetric information, borrowers and lenders participate actively in the market and there is no impairment to its functioning. However, riskier banks create an externality on safer banks. In turn, these know that their information is not perfect and impose a risk premium on their borrowers based on the average counterparty risk. In doing this, they subsidize the cost of liquidity of riskier banks. When the cost of subsidy becomes higher than the cost of getting liquidity outside the banking market, safe banks leave the market and this is the second regime where the interest rate on unsecured transactions rises. The ECB writes that “since the onset of the crisis in August 2007, the money market has become two-tiered, with banks in possession of high-quality collateral being able to attract funds at relatively low rates in the repo market, while second-tier (riskier) banks are having difficulties in attracting funds even at higher rates. It appears that not all banks have been equally impacted by credit risk concerns”. When the perception of counterparty risk becomes unbearable, then liquidity-rich banks prefer to store their cash at the central bank or in other less-profitable but safer opportunities and that is when the market breaks down. The central bank intervention is the only tool left and this is what happened since the end of September 2008.

In an article in the July Bulletin (http://www.ecb.int/pub/pdf/mobu/mb200907en.pdf), the ECB writes that “the main reasons why banks were less willing to engage in unsecured lending in the money market seem to stem from liquidity and solvency concerns, which were a result of asymmetric information and uncertainty. On the one hand, in times of volatility, banks are uncertain both about their own liquidity needs and their ability to obtain refinancing from the market in the future. On the other hand, a high degree of uncertainty about individual banks’ exposures, reinforced by market turbulence and the resulting decline in asset values, cast doubt on borrowing banks’ solvency and thus their ability to repay a money market loan”. In our view, when stressing the first reason, it seems the ECB is acknowledging that there were multiple factors at work and that some banks needed the central bank not because they were perceived as risky counterparties but because they were no longer sure to can count on all their historical funding sources.

This leads to another mantra that risks being dismantled by a closer look at hard evidence: the role of interbank market in banks’ funding at longer maturities. Indeed, most have been claiming that the crisis has brought about the unwelcome legacy that beyond very short-term maturities it is impossible to get funds in the interbank market. However, a closer look at the ECB euro money market survey shows that even before the crisis erupted, the role of the interbank market for these transactions was negligible. In the second quarter of 2007 (the last one before the crisis), of an average daily turnover of EUR 81bn, almost EUR 79bn involved transactions up to one month. Our impression is that it was money market funds instead playing a key role in providing liquidity at longer maturities. Anecdotic evidence (getting aggregate information on money market funds’ operations is almost impossible) tells us that these players (at least those who survived the crisis) have now become much more selective in choosing counterparties, probably fearing also a wave of stricter regulation bound to hit them in the near future. Large, too big-to fail banks that are perceived as safe are back in business with these funds at very advantageous borrowing conditions, whereas the bulk of small and medium players have the ECB as the sole provider of liquidity at longer maturities.

If our guesses are correct, then on the liquidity front the situation is far from being solved because there might well be the case that money market funds have become structurally more risk averse. In a speech given in Rome on September 11, ECB Board member Lorenzo Bini-Smaghi in discussing the central bank’s exit strategy – and the need not to impair the transmission channel of monetary policy once the central bank decides to lift rates – stated “It is not the central bank’s task to continue providing liquidity to financial institutions which are not able to stand on their own feet, once the turmoil is over. It is the responsibility of the supervisory authorities, and ultimately of Treasuries, to address the problems of these addicted banks as soon as possible, through recapitalization and restructuring as appropriate, and to ensure that all banks in their jurisdictions can stand on their own feet even without the central bank’s facilities”. Clearly, the ECB has a much better picture on what’s going on in the money market than we have, and these remarks seem to underpin – at least in part – our reading above. Being that the case, something must be thought out relatively soon for the longer-term liquidity needs of the vast majority of the euro area banking system. The ECB is still in a wait-and-see mode, but it won’t be for ever.