Last week the European Central Bank conducted its second round of Long Term Refinancing Operation, better known in these days of acronyms as LTRO, or even LTRO 2 after the first round of this type of LTRO was conducted last December. Whilst it is quite normal for the ECB to provide funding into the banking system, the size, duration and method of such funding is what has made this special.
Markets are driven by the collective actions of human beings who need to feel confident about the future to invest- David Curmi
Part of the ECB’s role is to influence interest rates and inflation by either withdrawing money from the banking system or by providing money for the system. In so doing, the ECB influences both interest rates in the banking system as well as the inflation rate. Banks normally “bid” for the money they need for short term cash flow purposes of one week or one month. In this case the ECB took the unusual step of allowing banks to borrow unlimited amounts of cash, against collateral, for three years at one per cent.
When announcing LTRO1 in December 2011, the objective of the ECB was multi-fold. It wanted to ensure that the risk in the banking sector was removed, albeit temporarily. At that time banks were increasingly weary of each other and were simply not lending. Given that interbank lending is one of the important elements that allows a banking system to function properly, the removal of this key component was like the restriction of oxygen to any healthy human being. It becomes only a matter of time as to when survival terminates. By providing unlimited lending to the banks the ECB ensured the survival of banks. In LTRO 1 banks borrowed some €489 billion whereas in LTRO 2, 800 banks borrowed some €529 billion. Though no official figures are released (welcome to the world of European transparency), a number of local banks also took advantage of this form of finance.
The ECB’s second objective, or rather hope in this case, was that the banks receiving this cash would use it by on-lending into the real economy in the form of loans to businesses and individuals. Although there are some early signs that lending is taking place, new loan data is still sketchy and in any case not substantial enough for the ECB to claim victory. There are clear signs though that LTRO has had major successes in other areas.
Banks who took part in LTRO funding have predominantly done three things with the money. 1) They have set aside the monies (ironically by placing the money back on overnight deposit with the ECB) to prefund redemptions of bonds coming up over the next 24 months or so. 2) They have taken part in the “carry trade” by buying government bonds that mature over the same period and make a profit of the yield pick up. 3) Alternatively they are buying back their own bonds, especially when these were most likely to be trading well below par, thereby handing a tidy profit to the bank.
Against this backdrop, perhaps the biggest net positive that this strategy has achieved is of putting confidence back into the markets. Confidence of survival of the banking system thereby allowing markets to reopen to banks. In fact since the January 1, 2012 banks have issued in excess €49 billion worth of bonds, more than the last six months of 2011.This indicates the state of the bank funding market in the second half of 2011. Having moved away from the brink of disaster, stock and bond markets have rallied strongly and possibly have further momentum to run. But in reality what has LTRO solved?
In truth nothing, except the important psychological aspect of confidence.
Markets are driven by the collective actions of human beings who need to feel confident about the future to invest! Thus, while market players exhale a collective sigh of relief as confidence is rebuilt, and start to put money back into the markets, banks can go about the business of rebuilding their balance sheets. And this is the key. So long as market confidence holds, banks can recapitalise themselves. If that confidence is sapped though, the problems are potentially a lot bigger than they were six months ago. This is because, by buying sovereign bonds with the LTRO funds, banks have taken on even more sovereign debt risk.
Should markets begin to doubt the viability of the EU plans on sustainable budget plans then yields on European government debt will spike again, as they did in December 2011, leaving banks to nurse substantial losses. Additionally, in three years time banks need to repay these loans. One hopes that by then the markets would have settled completely and banks will have access to raise finance again. Alas that is a problem for another day, and therein lies the challenge.
Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. It is based on public information and should not be viewed as investment advice in any manner. The value of investments may fall as well as rise and past performance is no guarantee of future performance.
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Mr Curmi is managing director of Curmi and Partners Ltd.