Confirming what we described in detail in March [13], Bridgewater's Ray Dalio notes in his Daily Observations that "Spanish banks' collateral is running out in a way that could force them into an ELA." The manager of the largest hedge fund in the world - so not some self-perpetuating political mouthpiece - estimates that the Spanish banking system has only a few hundred billion euros left in eligible collateral and that some of the weaker banks are likely already getting close to a point where their collateral is exhausted. Critically, if this occurs, then Spanish banks will need to turn to its own Emergency Liquidity Assistance (ELA) program. An ELA for Spanish banks would likely be several times the size of those in place for Greece and Ireland, further fracturing the uniformity of central bank standards across the eurozone, and the magnitude of funding coming through the national central banks could accelerate rapidly. This increasing Balkanization of European central banks and funding capabilities only entrenches the impossible task of fiscal union as 'more' sovereign control transfer will be required in return for any core backstopping. Furthermore, those who are hoping for LTRO3: no collateral, no deal! Which the IMF just confirmed is a flashing red warning:
- IMF: COLLATERAL AT ECB VULNERABLE TO DOWNGRADES, MARGIN CALLS
Just EUR300bn left in Spanish Collateral: Then What?
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An ELA for Spanish banks would likely be several times the size of those in place for Greece and Ireland, further fracturing the uniformity of central bank standards across the eurozone, and the magnitude of funding coming through the national central banks could accelerate rapidly.
Spanish Banks' Collateral Is Running Out in a Way That Could Force Them Into an ELA
We estimate that the Spanish banking system only has a few hundred billion euros left in eligible collateral. That means that some of the weaker banks are likely already getting close to a point where their collateral is exhausted. (We think this reality is the reason why we are seeing a number of legal changes in Spain that look like an attempt to scrounge up a bit more capital). if Spanish banks run out of ECB collateral, then the Spanish central bank would likely need to turn on its own ELA. The potential magnitude of such an operation would dwarf the nationalized money printing to date.
Spanish balance sheets can probably support about €800 billion of borrowing from the ECB. Between the ECB and privately secured funding, mostly foreign interbank, Spanish banks are already borrowing about €500 billion, and if private secured funding was pulled, this borrowing and related collateral could be shifted to the ECB. So we think about the remaining capacity to borrow as the total collateral borrowing capacity (€800 billion) less what is pledged to both the ECB and private lenders (€500 billion), or about €300 billion. However, this almost certainly overstates Spanish banks' collateral cushion because there are strong banks such as BBVA and Santander that probably have ample capacity and weaker banks that are likely much closer to being tapped out.
The attempt to manage the imbalances among the Euroland economies is an extremely dangerous highwire act, and to the extent that monetary policies diverge to serve individual countries' needs, the further capital flows will likely go in the opposite direction.
The Balkanization of European Central Banking Continues
We think that one of the bigger risks facing the Eurosystem is the continuing division in its central banking system. Wien the euro came into existence, the individual national central banks within Europe became mostly implementers of a common ECB monetary policy. But as the European debt crisis has dragged on, the national central banks have gradually begun to conduct policies that are creating a differentiated monetary policy between core and peripheral countries (as we'll describe below). The more the national central banks create easier policy within weaker parts of the eurozone, the more they stimulate money creation in the weaker parts of Europe that will logically flow to the stronger parts -- which will only put more pressure on the currency union.
The ECB's rejection of Greek government bonds as Eurosystem-eligible collateral is the most recent example of the growing balkanization, as it will require Greek banks to again turn to their national central bank's ELA for funding, an avenue that basically allows them not to adhere to the ECB's borrowing standards. The real looming risk, however, is in Spain. Spanish bank funding needs continue to grow, system-wide ECB-eligible collateral is running low (and anecdotal signs of banks seeking to create new collateral suggest to us that some banks are probably already almost out), and there is a real chance that the Spanish banks could soon need to turn to an ELA of their own.
An ELA for Spanish banks would likely be several times the size of those in place for Greece and Ireland, further fracturing the uniformity of central bank standards across the eurozone, and the magnitude of funding coming through the national central banks could accelerate rapidly.
Recall that, like the Fed, the ECB has a hub and spoke structure, with policy directed by Frankfurt and implemented by the national central banks (NCB's). But unlike the Fed, which has been around for a very long time and is the national central bank of a single, indivisible sovereign, the ECB is still in its infancy and represents a collective of 17 countries with very different risk tolerances, incentives, and historical perspectives. And importantly, these countries are not bound very tightly in a fiscal union. The ECB charter reflects this, providing a reasonable amount of autonomy and authority to individual NCB's, which was not utilized until the debt crisis. This autonomy has recently translated into the increasing use of emergency liquidity facilities (ELAs) and lending against non-standard collateral by the NCB's. And unlike standard ECB repo lending operations, these loans are solely backstopped by the applicable NCB and, if necessary, the domestic government in that country.
This creates a two-tier monetary policy - exactly what Draghi just tried to tell us he is avoiding.
The ECB has taken some steps:
Emergency Liquidity Assistance (ELA's)
NCB's received, under the original construct of the European Central Bank, certain autonomous rights, including the ability to determine their own policies with regard to the provision of domestic liquidity. However, few central banks ever actually operated outside the Eurosystem for more than very limited purposes. This changed with the onset of the sovereign debt crisis. Several NCB's have opened ELA's, which theoretically give them the ability to unilaterally set collateral standards, terms, and haircuts for lending to the domestic banking system. The risks arising from these ELA loans are borne by the NCB's (since these transactions are "outside" the Eurosystem) and backstopped by the domestic government. The ECB has the ability to shut down these facilities with a two-thirds vote of the governing council (and we believe that the ECB is involved in the set-up and maintenance of ELA's), but technically the NCB's do not require the ECB's approval to open an ELA. Our current estimate of ELA's is €180 billion.
Non-standard collateral
In concert with the recent LTRO's, the ECB announced an expansion in eligible collateral for repo operations. The NCB's had to submit for ECB approval the non-standard collateral they would accept. However, even with the ECB's approval, the risk of loans backed by non-standard collateral is borne by the individual NCB's, not the ECB. After the second LTRO, ECB President Draghi said that €53 billion of non-standard collateral had been accepted by the ECB. We don't know if this number has changed since that time. There is potential for this number to go much higher. It should also be noted that once again we saw differentiation across the NCB's. Only seven NCB's submitted plans to allow their banks an expanded pool of eligible collateral. Most core NCB's rejected the opportunity to ease collateral standards (the exceptions being France and Austria).