Mario Draghi’s quest for new liquidity tools is proving more complex than two years ago.
When the European Central Bank president decided in 2011 to provide euro-region banks with three-year loans to ease a credit crunch, liquidity and interest-rate policies were separate issues. Now, cheap funding has the potential to affect the ECB’s interest-rate guidance and prompt banks to shore up their balance sheets rather than boost lending to companies and households as they undergo a review of their accounts.
ECB officials are drawing up plans to keep money flowing to banks to head off a liquidity squeeze when the first round of emergency long-term loans comes due in early 2015. A technical committee tasked by Draghi to consider solutions has entered a second week of talks with no pressure for results, according to two euro-region central bank officials familiar with the matter who asked not to be identified because the talks aren’t public. An ECB spokesman declined to comment on the meeting.
“We are no longer in crisis mode, which gives the ECB more time to think about new measures without a big urgency to act,” said Marco Valli, chief euro-area economist at UniCredit Global Research in Milan. “But at the end of the day more liquidity will come and the next injection will probably take a different form than the last time around.”
The ECB is trying to nurture a nascent economic recovery by preventing short-term money-market rates from rising so fast they weaken banks and deter lending. Draghi told the European Parliament on Sept. 23 he’s “ready to use any instrument” to keep interbank borrowing costs at a level appropriate for the inflation outlook.
The rate banks expect to charge each other overnight by the ECB’s rate meeting next October stood at 0.21 percent today, up from 0.01 percent in mid-May. The yield on German two-year bunds has climbed to 0.18 percent from minus 0.03 percent over the same period.
New liquidity measures could comprise longer-term refinancing operations with fixed or floating rates, different maturities or rules on how banks must use the cash. Other possible measures include changes to reserve or collateral requirements; the suspension of liquidity-absorbing operations; or the extension of full-allotment loans.
“It is the intention of the Governing Council to provide liquidity insurance for banks and the banking system in Europe,” Draghi said on Oct. 2. “Nobody wants to have a liquidity accident occurring between now and the recovery.”
So far, the council’s intention has been reflected in words alone with Draghi’s pledge to ensure banks have sufficient liquidity. That might change if the U.S. Federal Reserve starts tightening its monetary policy, pushing global money-market rates higher, or the euro continues to appreciate, said Janet Henry, chief European economist at HSBC Bank Plc in London.
Market rates surged in June after Fed Chairman Ben S. Bernanke said the central bank may start reducing its $85 billion-a-month of bond purchases this year. Policy makers, who conclude a two-day meeting today, will probably delay the tapering until March, according to the median of 40 responses in a Bloomberg survey this month.
A stronger currency can depress prices and erode exports, slowing economic growth. The euro has gained 2.6 percent against a basket of currencies since early September and 4.8 percent against the dollar.
On the Cards
“More liquidity doesn’t seem to be on the cards anytime soon,” said Henry. “But there’s still a reasonably good chance we could see more loans being provided in the course of 2014, most likely in response to tapering by the Federal Reserve or a continued currency appreciation.”
While financial institutions have made use of an option to repay most of the ECB’s loans early, some banks in the periphery may struggle when the debt matures. That means any new loan would have to overlap the expiration date for the existing LTROs to address what economists have dubbed the refinancing cliff.
Another area to explore would be the rate charged on the loans. So far, the ECB has provided long-term liquidity at an interest rate tied to the average of its benchmark rate over the life of the loan. While that works alongside the ECB’s pledge to keep the refinancing rate at the current level of 0.5 percent or lower for an extended period, it doesn’t insure banks against an eventual rate increase.
An alternative would be to cap the interest rate on the loans, bringing funding conditions in line with the ECB’s guidance on borrowing costs. The ECB could even fix the rate at which banks can take out money. If that’s done at the benchmark rate, it effectively closes the door on future cuts in policy rates.
“A fixed-rate LTRO over a two to three-year period” would signal a “real commitment from the ECB to keeping rates low for a prolonged period of time,” said Michala Marcussen, global head of economics at Societe Generale SA in London. “It would be far more powerful than any verbal forward guidance” and could “potentially help oil the wheels of lending to the real economy.”
The risk is that cheap loans are extended too far into the future. Bundesbank President Jens Weidmann warned in June that accommodative policy must be withdrawn “at the right time” so that generous liquidity provision isn’t offered when a recovering economy stokes inflation pressures.
Another challenge is to prevent banks using new funds to strengthen their balance sheets rather than lend. The ECB will assess financial institutions next year to identify any capital shortfalls before it takes over as the euro-area’s single bank supervisor. Policy makers including Draghi have said liquidity should not be used to repair balance sheets.
“The situation this time around is much less dramatic than two years ago,” said Christian Schulz, senior economist at Berenberg Bank in London. “If you want to target interest-rate expectations, you should choose a rather generous tool. But if your goal is to give banks an incentive to become healthier, LTROs are not the right tool.”
Klaas Knot, the Dutch representative on the ECB’s Governing Council, said on Oct. 15 that it might be “worthwhile” to explore whether some kind of conditionality might be introduced in future euro-area refinancing operations to support the economy.
“The provision of additional liquidity could be made conditional on strict asset-quality reviews or efforts to build up adequate capital,” Knot said in a speech in Mexico. “This would contribute directly to restoring the health of the financial system.”
Long-term loans aren’t the only option for the ECB to increase funding supply to financial institutions. The central bank has already committed through the middle of next year to provide unlimited liquidity in operations with a maturity of as long as three months.
It could extend that pledge until after the existing LTROs expire to assure banks they will get the funding they need, said Mark Wall, chief euro-area economist at Deutsche Bank AG in London.
“It’s worthwhile to give the market a sense of security, and unlimited allotment signals certainty,” he said. “An extension of the unlimited allotment will play into the credibility of the ECB’s forward-guidance regime.”
Other choices include removing the ECB’s requirement for financial institutions to hold deposits at their national central banks, and stopping the sterilization of bond purchases conducted under the now-terminated Securities Markets Program, Martin van Vliet, an economist at ING Bank in Amsterdam, said in an Oct. 11 note. The ECB re-absorbs the liquidity injected through the SMP program to ensure its monetary stance isn’t affected.
The two options combined would free up as much as 290 billion euros ($398 billion), van Vliet calculated. That would more than double the excess liquidity currently in euro-area money markets, which stood at 181 billion euros on Oct. 28.
“Such non-standard measures, however, would be rather controversial,” he said. “Instead, the ECB might opt to take the path of least resistance and cut the refi rate, though this might require a downgrade of the inflation outlook, which seems less likely in the near term given the signs of recovery in euro-zone economic activity.”
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