Financial Stability News

News about financial stability, central banking and theory of money

Tag Archives: LTRO

On Covered Bonds, Collateral Crunches, And The Circular Logic Of Central Banks

This post by Zero Hedge gives a subjctive interpretation of the current rush of covered bonds by Europeans banks, some of them soon approaching the limits for such issuance. Many banks retain large portion of the new bonds themeselves; which raises the interesting question if you can own your own debt!

The post goes on to argue that central banks are painting themeselve into a corner, where lack of collateral and requirement of collateralized lending (from CBs to banks) will finally meet.

If, however, the covered bond bridge is pushing up against its very real statutory and quality limitations, that might mean the ECB is now fighting a two-front funding war – retail deposit flight and collateral diminishment at the same time. 

At that point the system will collapse or central bank will be force to relax collateral requirements, ref. Tuckers discussion of this problem under the heading of “central banks’ time inceonsistency problem”, for a discussin of this dillemma see my Levy WP here on The Collateral Squeeze, p. 17

Alternatively (and better), central banks should let failing banks go into resolution and stop the collateral chasing. Better to start on this process before it becomes too late.


Shadow banking and central bank liquidity support

Global liquidity provision is highly pro-cyclical. The recent financial crisis has resulted in a
flight to safety. Severe strains in key funding markets have led central banks to employ highly unconventional policies to avoid a systemic meltdown. Bagehot’s advice to “lend freely at high rates against good collateral” has been stretched to the limit to meet the liquidity needs of dysfunctional financial markets.  As the eligibility criteria for central bank borrowing have been tweaked, it is legitimate to ask how elastic the supply of central bank currency should

I address this question in a new Working Paper from Levy Institute: Shadow banking and the limits of central bank liquidity support. The paper review the recent expansion in central bank liquidity support, including their collateral polices, and then suggests that central banks should not unconditionally supply liquidity to a banking system that is growing uncontrolled. Stricter controls are required unless central banks again will have to underwrite dysfunctional markets.

The paper also provides input to the ongoing Krugman – Keen discussion on banking. See especially section 6 on excessive global credit and section 7 on A new view of banking.

LTRO will boost TARGET2 imbalances

This is technical stuff for the devoted, but still interesting background on the interactions between the new long term refinancing facility to ECB and the balances in the Euro payment system TARGET2.


ECB’s heavy haircuts

FT Alphaville gives further details today on the regional variations in collateral requirements for the upcoming LTRO . As noted by Draghi yesterday, ECB will apply a hefty haircut of 2/3 on all pledged collateral. But national central banks have discretion within the new collateral rules to accept local assets depending on circumstances. Generally, the new guidelines imply that NCB’s will accept assets with ratings down to BB- instead of previously BBB-. But there are variations between NCBs as noted in this report, e.g. CB of Spain will accept mortgages, while the Irish CB will not.

The Germans think the ECB is giving away “easy money”. That can be debated, with such a heavy haircut.

Highlights from ECBs press conference today

Lots of interesting tidbits here from ECB chief Draghi’s press conference today. My favorite quote:

The new Fiscal Compact is a major political event. For the first time governments are giving up some of their sovereignty and are ready to put this into their primary legislation. This is a sign that the Euro is strong. It is a first timid step to fiscal union. This will not be a transfer union! All countries should stand on their own without continued subsidies from the others

But, what is the point of being together if you have to mange alone??

I have included my notes below. There are some new info about the LTRO coming up end of month. See also recent Zero Hedge post for more on the weakening collateral position and what it say about the banking sector in Europe.

  • ECB has more optimistic outlook than IMF for Europe, especially for Germany
  • Don’t see substantial downside, but rather stabilization of economy at a low level
  • But lots of uncertainty!
  • EU (consolidated) is in much better fiscal shape than the US and Japan
  • Inflation expectations are well anchored and remain low
  • ECB is very concerned about the current credit crunch, especially to SME (account for 80 % of EU employment)
  • Normally large banks would take money from ECB and distribute locally, but with interbank market not working, we have to enable them to get it directly from us
  • Therefore the ECB has relaxed the eligibility criteria for LTRO collateral  to enable smaller bank direct access
  • This will expose the ECB to more risk, but the risk is very, very well managed
  • Loans will be over-collateralized by a lot (haircut of 2/3)
  • The first LTRO was used by many banks to refinance their own debt; also many are facing higher capital requirements
  • We expect more will be used for lending (and purchasing government bonds) in the next LTRO
  • What they use LTRO for will be their own business decision (we cannot force them to lend)
  • But we are looking very closely at what is happening (with lending) and will review our policy options in 6 month time
  • Size of next LTRO will be substantial and (probably) at around same level as the first one
  • LTROs are non-standard (extraordinary) monetary policy operations that should not be continued when we get back to normal (funding markets)
  • LTRO is not an alternative to a rate cut. LTRO is addressing quantity constraints and liquidity deficiencies. Interest rate changes would address pricing conditions, subject to normal functioning financial markets. Markets are not functioning now, therefore LTRO.
  • Difficult for us to say how large next operation will be. There is no stigma attached to LTRO borrowing! There has been some press reports that it is undignified to borrow from the new facility; such “manhood” statements are not correct. Actually many much better banks (than the one quoted) have taken funds under LTRO1. Since this crisis originated as a sovereign crisis, many banks in better placed countries will not need the money. They should thank their countries for being well managed.
  • TARGET2 imbalances are inherent in a monetary union. Some are in surplus while others are in deficit. These imbalances are usually not high under normal conditions. Since the interbank markets are not working now, some countries have accumulated balances and others have seen negative balances grow. However, this does not represent any more risk; it is part of the normal functioning of the ECB.
  • Greece should focus on reform, not refinancing
  • ECB will not take haircut; not our intention to violate monetary financing prohibition
  • European Financial Stability Facility (EFSF) is a Government institution, i.e. if we make a loss on a transfer of Greek debt to EFSF, it will be monetary financing (of Governments)
  • Another matter if ECB transfer part of its profits to EFSF (i.e. Governments); that is not monetary financing
  • The new Fiscal Compact is a major political event. For the first time governments are giving up some of their sovereignty and are ready to put this into their primary legislation. This is a sign that the Euro is strong. It is a first timid step to fiscal union. This will not be a transfer union! All countries should stand on their own without continued subsidies from the others
  • Q: Do you have a plan B for Greece? D: We never have plan Bs (we will work this out, but cannot say more until after the EU Council meeting tonight)
  • Whatever is decided of haircuts for Greece (Private Sector Initiative) should not lead to precedent for other countries (including Ireland)
  • Ireland should be commended for the bold and courageous measures that are being taken


€680Bn LTRO Take Up?

Zero Hedge reports today that Goldman has conducted a poll among among banks and investors about their views on the next ECB long term funding operation coming up end of February. The consensus is for a substantial increase, close to 680 trillion euro. But, as the post notes, if the banks use this to exchange weak assets for cash in ECB deposits account, it is essential paying interest to retain mirage of solvency. Question is how long this process can go on? Perhaps, as ZH notes, until hedge funds start shorting all the banks taking money in the LTRO? Time will tell.