Draghi $545 Billion Lure Ties ECB Rate Insurance to LoansJeff Black, Emma Charlton and Alessandro Speciale
Mario Draghi is offering banks a risky form of insurance.
The targeted long-term liquidity plan that the European Central Bank president unveiled yesterday allows lenders to hedge against the possibility that interest rates will rise over the next four years. In return, they must boost loans to companies and so take the risk that businesses in countries with weak demand can’t repay the debt.
“As a bank, you are getting out of this an insurance against rate hikes in year three or four,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London. “At the same time, you’re asking banks to take on credit risk. You have to believe there’s massive pent-up demand for credit to do that.”
Draghi is trying to jump-start lending that is still lackluster a year after the 18-nation euro area emerged from its longest-ever recession. His liquidity plan, dubbed TLTRO, makes funding of as much as 400 billion euros ($545 billion) available at current ultra-low rates.
The program comes against a backdrop of low inflation, mediocre economic growth and a bank balance-sheet review that reduces the incentive for euro-area banks to boost credit. While an ECB survey showed conditions for new loans stabilized in the first quarter, lending to companies and households has barely budged in 2014 and is down almost 2 percent from a year ago.
The ECB’s plan has similarities to the Funding for Lending Scheme adopted from 2012 by the Bank of England. Financial institutions will be able to borrow money equivalent to as much as 7 percent of their outstanding loans to companies and households, excluding mortgages.
“It’s an attempt, a very well thought-out experiment,” ECB Governing Council member Ewald Nowotny said in Vienna today. “How successful it really is depends on many factors.”
The TLTROs will have maturities of up to four years and be priced at the ECB’s benchmark rate at the time they are issued, plus 0.1 percentage point. From March 2015 to June 2016, banks will be able to borrow as much as three times the amount of their net lending to euro-area companies, above a threshold set by the ECB.
European bank stocks rose. Shares in UniCredit SpA, Italy’s largest bank, Spain’s Banco Sabadell SA and National Bank of Greece SA all surged at least 5 percent yesterday before extending gains today.
The TLTRO represents “cheap funding, so the banks will take it up,” said David Owen, chief euro-area economist at Jefferies International Ltd. in London. “If the banks want to get lending going forward, the omens are not nearly so good. If you look at the example of the U.K., here loans are still contracting to non-financial corporations, even with cheaper funding.”
BOE data shows lending to non-financial businesses fell by 4.1 percent in the 12 months to April and credit to small and medium-sized enterprises slid 3 percent.
Draghi said officials will step-up their monitoring activities to make sure euro-area banks lend the cash rather than loading up on government debt with a lower risk of default. Banks that don’t lend the money on will be obliged to repay it after two years.
In its last round of long-term loans in 2011 and 2012, as a funding crunch in the financial system loomed, the ECB injected about 1 trillion euros without conditions. Some banks used the funds to conduct a carry trade, using the cash to buy higher-yielding bonds.
The ECB wants to “make sure that this credit-enhancing measure is actually going to be used to lend to the real economy,” Draghi said yesterday. The ECB also cut its benchmark interest rate and took the historic step of introducing a negative deposit rate, meaning it’ll charge banks that keep their excess cash at the ECB.
Even so, persuading banks to lend into economies that are still reducing debt and suffering from recession may be a tough sell. The value of defaulted loans in Spain has almost doubled since 2010 to total 193 million euros in March, according to Bank of Spain data.
The incentive to take up the TLTRO loan now would increase if banks believed borrowing costs will rise over the term of the loan. In a sign of that possibility, the ECB tweaked its communication on the future path of interest rates to remove a pledge to maintain a downward bias.
Official rates “will remain at present levels for an extended period of time,” Draghi said. He previously promised that rates will stay at “present or lower” levels.
The sluggish market for bank loans in Europe is also partly due to the ongoing review of bank balance sheets being conducted by the supervisory arm of the ECB. The unprecedented Comprehensive Assessment, coupled with tougher minimum capital requirements, is giving lenders pause for thought.
Draghi acknowledged that when he said that “banks should take full advantage of this exercise to improve their capital and solvency positions.”
With the ECB’s main refinancing rate now at a record low of 0.15 percent and the euro-area economy expanding, albeit slowly, the TLTRO still means that for a small premium banks can boost their profitability by locking in low funding costs as they expand lending.
“It has the incentives there,” said Sarah Hewin, head of research at Standard Chartered Plc in London. “The fact that you can triple up on your net lending if you are lending to corporates is an incentive, so it ought to have an impact.”