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Monday, 2 June 2014

An enticing Very Long Term Refinancing Operation from the ECB

Since the last press conference of the ECB President, several members of the Governing Council have confirmed that the ECB is preparing a package of measures to be decided at the next meeting of the Governing Council. I have given my sense of what could be the content of this package, as well as its interest rate consequences, in a previous post [1]. In a more recent Tweet I have increased the probability, up from 60 per cent, of a negative deposit rate being part of the package.

Draghi has recently more or less announced that one component of this package will have to deal with credit constraints, in particular in the periphery, which is experiencing a particularly low, in some cases negative, inflation. At the recent Sintra conference he stated that:

"Our analysis suggests that credit constraints are putting a brake on the recovery in stressed countries, which adds to the disinflationary pressures.
An intermediate situation is one where credit supply constraints interfere with the transmission of monetary policy and impair the effects of our intended monetary stance. This would require targeted measures to help alleviate credit constraints. 
If, in this context, availability of term funding is a limiting factor on loan origination, then monetary policy can play a bridging role. Term-funding of loans, be it on-balance sheet – that is, through refinancing operations – or off-balance sheet – that is, through purchases of asset-backed securities – could help reduce any drag on the recovery coming from temporary credit supply constraints."

These statements are, in my view, as close as he could go in anticipating that one component of the package will be a new Very Long Term Refinancing Operation (VLTRO).

My understanding is that this measure could be effective when joined with the cleaning and the recapitalisation of bank balance sheets that the Comprehensive Balance Sheet Assessment is already bringing about, even before the process will be over, towards the end of this year. I would add that a VLTRO that would meet a high demand from banks would also help on the liquidity front: high demand by banks would increase excess liquidity and thus help keep EONIA close to the bottom of the ECB interest rate corridor. Draghi has repeated a number of times that he does not particularly care about volatility of EONIA as long as this does not spillover in longer money market maturities, but I think that a stable EONIA should be welcome.

If a VLTRO will indeed be part of the package, which characteristics would make it enticing for banks? Two preconditions have, in my view, to be fulfilled: first, the new VLTRO should have the interest rate fixed, or even better capped, at the new, lower Main Refinancing Operation rate, which I guess would be 10 basis points; second, there should be an attempt to reduce stigma and thus the fear of banks being considered weak if they borrow large amounts from the ECB [2].

Another factor which could contribute to the enticement would be an appropriate maturity. Should the new VLTRO have the same three year initial maturity as the ones that will expire at the turn of the year? Or longer? Or shorter?  A criterion to decide about the best maturity would be to compare the financial cost of the new VLTRO, i.e. the reduced MRO rate, to the yield curve of rates that are relevant for the funding of banks. This is done in the chart below, in which the yield curves of Overnight Index Swap, Euribor/SWAP and German sovereign securities are reported together with the presumed MRO cost.

Chart 1: European money markets and sovereign curves 
Source: Bloomberg
EURO Swaps: This curve represents Euro-denominated interest-rate swaps.  The short-end of the curve are Euro interbank offered rates (Euribor).  Payments on the long end of the curve are based on fixed-rate versus a floating-rate  contracts with the fixed-rate portion on an annual and the floating-rate on a semi-annual  from the Euribor six-month rate.
German Sovereign:  The curve is built out of the most recently issued or closest current nominal maturity government security.  The 3-month and 6-month maturities are Treasury Bills. The 1-year and 2-year maturities are either Treasury Bills or notes. The 3-year, 4-year and 5-year are German five year bonds. The remaining points of the curve are German Government bonds of the relevant maturity.
EURO OISThis curve represents Euro-denominated overnight index swaps.  Payments are based on a fixed-rate versus a floating-rate overnight index with the fixed-rate leg on an annual basis from the effective overnight index average rate (EONIA). 

Just looking at the chart does not provide an immediate answer about which maturity would enhance the attractiveness of a new VLTRO. In particular results depend on which curve one takes as most relevant for the funding of banks. If this was the Euribor/swap curve, i.e. unsecured borrowing, then ECB lending at a fixed or capped 10 bp would be attractive for any maturity. If one would look, instead, at secured borrowing, as approximated by the OIS or the German security curve, the ECB should reach to maturities of 4 years or longer to provide a "cheap" source of funding.

Three additional considerations can help, however, to reach less indeterminate conclusions.

First, fairly large borrowing from the ECB still takes place even if the 25 basis points cost of MRO borrowing is well above OIS or short term German securities yield for maturities up to 3 years, indicating that the latter two rates are not good indicators of the cost of funding for banks (if they could borrow at that low cost from the market banks would not borrow from the ECB at a higher cost).

Second, and connected to the first point, the collateral eligible for borrowing from the ECB is much wider than that usable on market repos, so, even if borrowing from the ECB is secured, its cost must be somewhat higher than what prevails on the repo market (approximated in the chart by OIS).

Third, notwithstanding what is mentioned above, about the need to fight stigma, it is unlikely that the ECB will manage to completely eliminate it from banks worries. In a previous post [3] I have guessed that stigma doubles the current cost of borrowing from the ECB, from 25 to some 50 basis points. Assuming that the level of stigma is not constant in basis points but somehow depends on the MRO rate and that the ECB at least partially manages to convince banks that borrowing from it is not a sign of weakness, we can guess that stigma would be worth 15 basis points after the rate cut instead of 25 currently, so that the "stigma augmented" cost of borrowing from the ECB after the rate cut could be 25 basis points. 

Comparing this cost with the current yield curves shows that a 2 year maturity would probably not be attractive enough, as the cost of ECB funding would be only 10 basis points below the relevant Euribor/Swap rate. Instead the 3 year maturity would already be quite generous, considering that the relevant Euribor/Swap rate is close to double this level and that the rate for OIS and the yield on German paper of the same maturity is around 10 to 20 basis points. A four year maturity would, of course, be even more attractive for banks, but would the ECB really want to  ease monetary policy so much and commit for so long? In my view a repeat of the 3 year maturity would establish a good compromise between providing an attractive proposition to banks and not committing for too long.

Another factor determining how attractive a new VLTRO could be for banks would be the possible constraints attached to it: the more the constraints the less the attractiveness. In particular many observers expect there may be a direct link between the amount banks could borrow from the ECB under this new facility and the increase of lending to firms. There are a number of reasons why I doubt that it would be useful to establish a hard link between the possible borrowing under this facility and the lending to firms:
  1. This would be an operational nightmare as it may require controlling the balance sheet developments of potentially thousands of banks;
  2. The experience in the seventies and eighties of Banca d´Italia with the "Massimale sul Credito" and the "Vincolo di portafoglio" as well as that of the Bank of England with the "Corset", which were specular measures trying to directly limit the credit to the private sector, show that  banks learn very quickly to "game" the constraints and an unending chase starts between the central bank trying to enforce the limits and the banks trying to escape it;
  3. I doubt the consistency of these types of measures with the ECB Statute prescription that: "The ESCB shall act in accordance with the principle of an open market economy with free competition,...";
  4. The experience of the Bank of England with its "Funding for Lending Scheme" is not really encouraging.
Still the ECB could avoid that a new VLTRO funds again carry trades, as the existing ones did. Indeed, it could reinforce the message that, in its role of supervisor, it will somehow penalise excessive concentration of banks balance sheets in national government securities, especially in the forthcoming stress tests.  

So, in conclusion, the ECB could provide a new, enticing VLTRO to banks, which could effectively complement the likely reduction of its rates. If the ECB would further add some concrete action on ABS and the promise that the resulting package could be followed by more action if still inflationary expectations would not return to be "firmly anchored", I hope that the market reaction could be favourable.

[***] Madalina Norocea provided research assistance

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