EKIP– Expert Club for Economics and Politics A Different Opinion
On February 29 this year, the European Central Bank (ECB) implemented its second liquidity injection of low-interest three-year loans (the so-called Long Term Refinancing Operations (LTRO)) for the banking system in the eurozone. The amount of loans provided was 529 billion euros and over 800 credit institutions benefited from it. In the first operation, conducted in December 2011, loans of 489 billion euros were granted to 523 banks. In both cases, the interest rate is 1%. As is noticeable, the number of those wishing to receive such cheap financing is increasing – these are mainly a large number of small institutions participating in the second tranche. This statistic is worrying, because the most likely reason for the increased number of borrower banks is the difficulties that more and more credit institutions in the eurozone are encountering in financing their business from the markets.
Through the operations under consideration, the ECB is trying to prevent a liquidity crisis in the European banking sector. This goal was achieved with the first tranche of the operation, as can be seen in Chart 1, which shows the dynamics of the three-month EURIBOR – the interest rate on the interbank market or, in other words, the price of interbank lending. The interbank market is very important for maintaining liquidity in the system. Usually, an increase in the interest rate on interbank financing is associated with an increase in risk. As can be seen in the chart, EURIBOR marked a gradual increase from mid-2010 to the end of 2011. It was the ECB’s LTRO 1 operation in December 2011 that managed to bring calm to the market and reduce interest rates.
Chart 1: Dynamics of the three-month EURIBOR for the period March 2009 – March 2012
Another argument for the ECB’s three-year low-interest loans is that some of the money could be used to buy bonds from countries on the periphery of Europe, which would lead to a decline in interest rates on these securities. This goal also led to the results expected by the ECB, after interest rates on bonds in a number of countries fell over the past 2 months. (See Table 1)
So much for the positive effects of this lending. Although the ECB operation managed to prevent a short-term crisis in the banking sector in Europe, it in no way addresses the problems in this sector and the reasons for their emergence. Moreover, it does not exclude the possibility of proving in the long term that the LTRO caused more harm than good.
The reasons for my skepticism are as follows:
1. Most likely, a very small part of the injected funds will reach the real economy. In Chart 2 I have presented the amount of deposits of Eurozone banks in the ECB, where it is clearly seen that the large jumps in these deposits were in December 2011 and the beginning of March 2012, coinciding with LTRO 1 and LTRO 2, respectively. On March 1, 2012 (one day after the start of LTRO 2) deposits in the ECB increased by 302 billion euros, i.e. more than half of the funds provided to banks were deposited in the central bank.
Graphics 2
This has at least two negative consequences. First, banks receive 0.25% interest on these deposits, and since they pay 1% interest on the same funds, the net effect is a loss of 0.75%. Second, this action by banks indicates a high level of risk. By depositing their money safely with the ECB for a return of 0.25% per year, banks are signaling that they are currently unable to find a more profitable investment for these funds. Consequently, there are currently not enough solvent and reliable investments in the real sector of the economy for banks to lend.
2. The debt from LTRO operations has a higher priority than other bank debts, i.e. if a bank becomes insolvent, it will have to repay its debts to the ECB first. This creates a problem for possible future financing from other sources, because either there will be no one willing to lend funds, or a higher interest rate will be required.
Overall, the LTRO 1 and LTRO 2 operations managed to bring temporary calm to the financial markets and prevent a liquidity crisis in the banking sector in Europe. Part of these funds were used to purchase debt instruments of countries on the periphery of Europe, which lowered interest rates on these securities. The latter could turn out to be a very profitable investment. When investing the funds from a loan with a 1% interest rate in securities bearing a return of 3-4% per year, a profit is made from a not bad spread (the so-called carry trade). The question is, however, how will the banks repay these funds in three years, especially since most of them currently bear a negative nominal interest rate. ECB President Mario Draghi said that LTRO 2 would put an end to low-interest loans to credit institutions in the eurozone, but this scenario is possible only if the economies of the single currency bloc begin to recover. Unfortunately, there are no such prospects for now.
Meto, in my opinion, it is too early to draw conclusions about the use of money from liquidity operations by banks... There is still plenty of time to use this money and for banks to profit from it. It is even better not to rush so much with lending to the real economy, but to gradually increase lending.
However, European government bond yields fell, thanks to the same banks and the "bad" speculators, which was one of the main indirect targets. Capital markets have literally skyrocketed in recent months, especially yesterday, helped by the Fed's continued loose policy.
However, once the liquidity outflow begins, it will certainly become clear which banks are weak in Europe and there will most likely be a period of consolidation. However, mass bank failures are hardly expected given that all the attributes of a functioning market economy are in place and the ECB no longer has to push the cart with the banks.
Kosyo, I don't know to what extent an economy in which the central bank sets interest rates and injects huge amounts of liquidity into the banking system can be called a market economy, but that's another question. Otherwise, in my opinion, this will not be the last LTRO. Europe is just entering a recession and until a real recovery begins, there will be more liquidity injections. Otherwise, you are right about the use of these loans. We will see how they will be used in the future. On the other hand, it is good for this money to gradually enter the real economy, because if this happens suddenly, inflation will follow, and no one wants that in a stagnant economic environment.
Yes, a market economy should not, in principle, tolerate such interference from the state/central bank, but nowadays, in my opinion, it is impossible to have such a situation, given that there are banks with about 10 percent of GDP in assets. It is unlikely that any democratically elected government would want to lead its country into a double-digit contraction of its economy when one or more of these banks fail, and it should not. In my opinion, it is precisely the size of the banks that is to blame for their being so carefully guarded by the state authorities.
Regarding the ECB becoming a Fed-style central bank, I think it should be noted that such a refinancing operation is quite unique in its nature. The QE was not a loan to banks, but a direct purchase of financial instruments, which directed investors as much as possible from low-interest bonds to the capital market (which is still unfolding)... LTROs are loans to banks that can be called at any time and have a maturity. The recapitalization of banks is also interesting how it will be carried out, given that many of the Anglo-Saxon banks were recapitalized by the state back in 2008. So the Eurozone is already 3-4 years behind other developed economies in fighting the crisis, which certainly highlights the clumsiness of the multi-directional and multi-speed system that we have in Europe at the moment.