With the second version of the ECB's enhanced LTRO (back-door QE) starting tomorrow, there has been a great deal of speculation on what the take-up will be, what banks will do with the funds they receive, and more importantly how will this effect global asset markets. SocGen provides a comprehensive top-down analysis of the drivers of LTRO demand, the likely uses of those funds, and estimates how much of this will be used to finance the carry trade (placebo [20]or no placebo). Italian (25%) and Spanish (20%) banks are unsurprisingly at the forefront in their take-up of ECB liquidity (likely undertaking the M.A.D. reach-around carry trade ) and have been since long before the first LTRO. On the other side, German banks have dramatically reduced their collective share of ECB liquidity from 30% to only 6%. SocGen skews their detailed forecast to EUR300-400bn, disappointing relative to the near EUR500bn consensus - and so likely modestly bad news for risk assets. Furthermore, they expect around EUR116bn of this to be used for carry trade 'revenue' production which will however lead to only a 0.6% improvement in sectoral equity levels (though some banks will benefit more than others), as they discuss the misunderstanding of LTRO-to-ECB-deposit facility rotation. We, however, remind readers that collateralized (and self-subordinating) debt is not a substitute for capital and if the ECB adamantly defines this as the last enhanced LTRO (until the next one of course) then European banks face an uphill battle without that crutch - whether or not they even have collateral to post. Its further important to note that LTRO 2 cannot be wholly disentangled from the March 1-2 EU Summit event risk and we fear expectations, priced into markets, are a little excessive.
[ZH: What we do note is that this is unlikely to be a Goldilocks moment. Too small an uptake, as SocGen expects will lead to risk-off and disappoint markets. Too large an uptake, in our view, will also shock the market - the greater stigma and rising subordination of assets via collateralization will hurt senior unsecured credit and implicitly cost of funding medium-term (shutting private funding channels and increasing public funding dependencies) - leading to risk off. Unless we see EUR475-EUR525bn - just right - then we suspect we will see risk-off either way.]
[21]
The LTRO Stigma remains a concern as LTRO-banks have recently underperformed no-LTRO banks and continue to trade with quite a spread premium.
Societe Generale: LTRO-2: Top-down
Give and take
Under normal circumstances, the ECB provides liquidity to the eurozone banking sector through variable rate tenders, where the allocation is rationed according to how much the system needs. These needs are defined by the autonomous factors and required reserves, which the ECB has a good understanding of. Nowadays, the ECB runs fixed-rate full allocation tenders, where banks can get as much as they want.
Call it back-door Quantitative Easing: banks effectively decide how much money is created but the ECB does not take assets off its balance sheet. Indeed, banks collectively take much more than the system needs. In good part, this is because cash-rich banks are reluctant to lend to cash-poor banks, even if that means they have to deposit money back at the ECB and get very low returns (currently 0.25%). Even cash-rich banks might want to take ECB liquidity on a precautionary basis (e.g. fears that it may be hard to roll over maturing debt) or because they see profit opportunities.
Italian and Spanish banks the main takers
National central banks release monthly data on domestic commercial banks’ operations with the ECB. Unfortunately, these data come with various lags. Most countries have, by now, released data for January. The chart below shows which national banking sectors have most increased their take-up of ECB liquidity recently. Italy and Spain lead the pack, followed by France (we show below that they do not make the same use of the cash).
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The chart below shows the share of each national banking sector in total ECB lending.
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Again, Italy and Spain now take the biggest share, at respectively 25% and 20% of total ECB lending. It is interesting to note that Irish banks have not increased their take-up of late, though it must be noted that the ECB data does not give the full picture for Irish and Greek banks, which both use emergency liquidity assistance (ELA) programmes. These programmes make it possible for banks to borrow directly from the national central banks, where they often post collateral that is weaker than that used at the ECB. The Irish central bank has already provided data for January, but the latest data available for Greek banks is for November.
Money does circulate!
Very early this year, we strongly dismissed the idea, so often heard in the press, that the surge in the ECB Deposit Facility (DF – see chart below) was proof that the LTRO was useless (as the cash returns to the ECB). This is a gross misunderstanding of what the ESBC balance sheet is. The surge of the DF pretty much says nothing about what the banks do with the cash. Banks take far more ECB liquidity than they need and whatever they do with it (e.g. put it back into the ECB or buy sovereign bonds), the excess naturally flows back to the ECB. Mr Draghi himself later supported our view, by noting that the banks that borrow the LTRO are not necessarily the same as those that deposit cash. With national central bank data progressively unveiling statistics for December and January, we can provide evidence of this.
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The chart below shows how much of the ECB liquidity, in each country, is deposited back at the ECB. The rising trend at the eurozone level - now above 50% - is mechanical.
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- Germany has a very high ratio, at 255% (the latest data on Deposit Facility usage is for November, but we expect an even higher ratio in January as the DF usage probably rose more than borrowing, from €22bn in November to €49bn in January). In other words, banks established in Germany deposit about 2.5 times more than they borrow. The German bank sector is thus very cash rich overall (this says nothing about individual banks).
- The same ratio for France stands at 50%, suggesting a relatively cash-rich situation (ECB lending primarily covers the need related to the autonomous factors and required reserves, so in normal conditions the Deposit Facility/ECB lending ratio would be very low).
- The same ratio for Ireland and Greece stands at 1-2%, i.e. banks borrow 50-100 times more than they deposit: the banking sector overall is very cash short. A very low ratio in a period of large aggregated excess cash at the eurozone level suggests funding difficulties. Portuguese banks’ borrowing has been very stable, around €45bn, and unaffected by the LTRO (January data available). However, we do not have Deposit Facility data for Portugal.
- The Italian ratio stands at 6% (by end-December banks had borrowed €210bn and deposited €12.3bn). The Spanish ratio is healthier, at 17% (28/161) by end-January (again, the aggregated number may mask individual bank stress).
All in all, it is clear that it is not the same banks that borrow from and deposit into the ECB. The LTRO thus helps greatly in easing stress in specific national banking sectors.
LTRO-2: the drivers
The take-up at LTRO-2 depends on the reaction function of the banks, within a constrained environment. We discuss the reaction function in the bottom-up section: banks might or might not want to go to the LTRO. If they do, they can use the cash for precautionary funding or opportunistic trades. For now, let’s focus on the constrained environment.
Extended collateral pool On 9 February, the ECB’s Governing Council approved eligibility criteria for additional credit claims. Mr Draghi estimated the widened collateral pool at €600-700bn only, or €200-300bn post (large) haircuts. The Bank of Italy indicated that the extended collateral would help Italian banks get €70-90bn of new cash, if they were to fully use the newly eligible collateral. To our surprise, only seven central banks have put forward relevant proposals. Presumably, the others (the four AAAs and Belgium in particular) did not like the plans (the decision was not unanimous) or felt that their banks did not need a broader pool of collateral. Importantly, the seven central banks will be responsible for the risk taken on the additional credit claims. We do not see the risk as high, given the large haircuts, but this sends an unpleasant signal of rising EMU fragmentation.
Banks that are short of collateral are actually getting more support, e.g. on 22 February the European Commission approved the extension, until 30 June 2012, of a scheme making it possible to provide state guarantees for credit institutions in Italy, initially approved in December 2011. We assume that banks, unless they are in a desperate situation, would aggressively use such a temporary arrangement to access 3-year liquidity.
Regulatory requirements – less stringent?
Looser collateral rules will essentially help small banks that cannot access market funding and face a shortage of collateral. It will also help banks to improve their LCR (liquidity coverage ratio), at least as long as this ratio treats sovereign bonds favourably. For banks looking at profit opportunities, regulators seem to be making the sovereign carry trade less painful. EBA (European Banking Authority) capital rules are being reviewed. The EBA had asked the banks to achieve a 9% Core Tier 1 ratio by mid-2012, and to hold an additional buffer against peripheral debt holdings. The latter constraint may be eased5. In any case, the EBA is not expected to run stress tests this year.
Last order?
There is some vague talk about the ECB ‘preparing to close the floodgates’6: the bank wants to become less generous in providing liquidity to commercial banks, making the 3-year LTRO of 29 February the last one. Instead, we expect the ECB to remain pragmatic, and adjust support to financial conditions. Still, such a threat, even if vague, could support demand if that is the final opportunity for banks to get this long-term liquidity.
Risk matters: the sovereign carry trade remains a dangerous game
We can guesstimate how much banks would take for precautionary funding, as we do in the bottom-up section. Estimating how much they will borrow to run carry trades is far more difficult. It is not just regulatory needs that will drive the decisions. Some banks will decide that the sovereign carry trade is just too dangerous, and will stay so until policymakers come up with nuclear solutions, which we think will involve both deep structural reforms (cutting long-term entitlement spending and addressing competitiveness issues) and stronger support, either in the form of bigger fiscal transfers (but political and legal constraints) or true QE. For now, running large sovereign carry trades is exposed to sudden deterioration in sentiment, and that can easily occur in a environment where the negative feedback loop between fiscal tightening and the recession has not been broken.
A turn in sentiment can quickly become self-sustained, as banks need to rebuild their pool of collateral when the price of the assets pledged at the ECB declines. This could eventually cause a collateral squeeze for banks that pledge a large part of their assets at the ECB or through covered bond programmes. Worse, a high mobilisation of assets also increases the risk for other creditors, and would cut those banks from unsecured borrowing for longer.
Finally, it is unlikely that large banks, which have been reducing sovereign exposure to assuage market concerns, would aggressively rebuild positions quickly, although fundamental concerns have not disappeared.
Size matters – Short-term market implications
Our forecast (€300-400bn) is on the low side of market expectations (close to €500bn, if one believes the latest Reuters survey). The market reaction should be fairly straightforward: a large take-up, say above €600bn, would be seen as a sign that banks are well funded, and more likely to hold sovereign bonds. That would be bullish for risk assets. A low take-up, say below €400bn would be seen as a signal that banks have little appetite for the sovereign carry trade, and still keen to deleverage: bad for risk.
But the LTRO cannot be completely separated from another key event, just a couple of days later: the EU 1-2 March Summit. A large LTRO and a 50% increase to €750bn of the rescue mechanism would be 'risk-on' (would also make us heavy sellers of Bunds vs swaps). But we fear disappointment on both sides. In rates space, we thus skew our portfolio of trades, in particular in the short-term basis space, towards risk-off conditions.
[ZH: What we do note is that this is unlikely to be a Goldilocks moment. Too small an uptake, as SocGen expects will lead to risk-off and disappoint markets. Too large an uptake, in our view, will also shock the market - the greater stigma and rising subordination of assets via collateralization will hurt senior unsecured credit and implicitly cost of funding medium-term (shutting private funding channels and increasing public funding dependencies) - leading to risk off. Unless we see EUR475-EUR525bn - just right - then we suspect we will see risk-off either way.]