Tuesday, January 17, 2012

The Eurozone liquidity glut

The ECB is orchestrating a Eurozone liquidity glut on an unprecedented scale via their measures to support bank liquidity. It helps the banks to remain liquid and improve their net-interest margin (which in turn helps profitability). Additionally, it also lowers the pain from the significant amount of bank bond redemptions this year and eases the need for banks to deleverage. Furthermore, it has the effect of driving down the external value of the Euro (thereby helping the Eurozone to gain market share and the weak peripheral economies to regain competitiveness at least vs. the non-Eurozone countries) and depressing short-end yields across the credit spectre (thereby easing the pain for the weak peripheral economies and helping the sovereigns to place their new issues). Finally, the resulting higher prices for peripheral bonds strengthens banks' balance sheets. Overall, I think that the second 3y LTRO at the end of February could see a massive take-up and that the ECB's measures are still underappreciated in the market.

I already mentioned in The ECB's XMas Present dated Dec. 19 that I regard the new 3y LTRO by the ECB as an "extremely positive development" and that I expect a huge take-up in the two announced LTROs. In the meantime, the first LTRO took place which resulted in a take-up of EUR 489bn and a net liquidity injection of a bit more than EUR 200bn. Additionally, judging from last week's press conference, ECB president Draghi seemed relaxed about this result and hence we should not expect the ECB to tighten their stance on the upcoming second LTRO at the end of February. For this liquidity operation, I expect an even larger take-up than in December. The easing of the collateral rules which now allow to pledge bank loans meeting specific criteria were not in effect in December given that the national central banks did not yet produce the necessary paperwork. However, Eurozone banks hold approx. EUR7trn in bank loans out of which probably around a fourth to a third might be eligible. Given the very low interest rate on the LTRO of currently 1%, banks don't seem to be able to get cheaper financing of such rather illiquid assets elsewhere. Hence, it makes a lot of sense to fund as much as possible via the upcoming LTRO in order to a) secure financing b) lower financing costs and c) free higher-quality collateral to be used for other transactions. The direct effects will be that the bank system liquidity is secured and the funding pressures on the Eurozone credit markets will ease.
There are approx. EUR 800bn in bank bonds (senior & covered bonds as well as government guaranteed bank bonds) coming to maturity this year. Out of which almost EUR 200bn are government guaranteed paper which were originally issued following the bankruptcy of Lehman Brothers and carried an average coupon of 3.5%. Hence, the effect on the net-interest-margin of Eurozone banks and thus P&L should be substantial. Assuming a total take-up in both operations of EUR700bn (i.e. assuming a net liquidity injection of EUR500bn at the end-of-February LTRO) and using the government-guaranteed cost of funding of 3,5% (which clearly underestimates the true savings in financing costs) suggests a reduction in financing costs of 2,5% p.a. which would equal EUR17.5bn p.a. or approx. EUR50bn over the life of the 3y LTROs.

For the markets, this should have several effects:
a) The external value of the Euro should continue to fall given the rising Euro-glut. The chart below shows the ECB's balance sheet vs. the EUR-USD exchange rate as well as vs. the trade-weighted Euro. As can be seen, during periods of a rising ECB balance sheet (mainly on the back of the liquidity support measures for the banking system), the Euro was in a downward trend which should remain the case. A weaker Euro would also help the Eurozone export sectors to gain market share.

ECB balance sheet vs. external Euro value
Source: Bloomberg, ResearchAhead

b) Short-end carry products should be in demand. Despite the recent fall in yields, the average yield of 3y Belgium/Italy/Spain government bonds is still around 3.4%, i.e. banks can buy these bonds in the secondary market, finance it via the ECB and earn 2.4% p.a. In turn, this should be seen as the main reason why peripheral spreads have tightened markedly over the past weeks.

2-10y Box spreads: Curve normalisation following announcement of 3y LTRO

Source: Bloomberg

c) The higher valuation of government bonds supports bank balance sheets. Given that Eurozone banks hold a significant amount of government bonds on their balance sheets, the fall in government bond prices has weakened bank balance sheets substantially and hence the sovereign crisis also resulted in a banking crisis. Now, however, as sovereign bond prices are rising (given that banks have come back on the buying side), the banking sector balance sheets appear stronger again.

The ECB is orchestrating an unprecedented Euro glut which supports the banks and sovereigns alike. The demand for funds at the second 3y LTRO at the end of February should be very large and its impact should not be underestimated!


  1. Do you have the specific criteria that bank loans have to meet to be eligible for collateral?

    Thanks Olivier

  2. Hi Olivier,
    thanks for the question. So far we don't know much. The ECB stated on December 8: "The NCBs are allowed, as a temporary solution, to accept as collateral for Eurosystem credit operations additional performing credit claims that satisfy specific eligibility criteria. The responsibility entailed in the acceptance of such credit claims will be borne by the NCB authorising their use. Details of the criteria for the use of credit claims will be announced in due course."
    Hence, it is up to the national central banks to decide but I have not seen anything yet. Judging from what the ECB did with the ABS collateral rules (where they lowered the rating threshold to A), however, the criteria should cover a substantial amount of the bank loans (I guess it will be similar to the ABS, i.e. cover performing loans to small and mid-sized corporates with a certain rating threshold).
    Best regards,