LTRO: A User's Manual

LTRO is the acronym given to the European bank lending program that has been compared to the "quantitative easing" initiatives of the U.S., known as QE I and QE II, and to similar measures undertaken by Japan and the United Kingdom. This European program was initiated by Mario Draghi, the newly appointed President of the European Central Bank, or ECB. Two LTRO tranches have been announced so far, one that took place on December 21 of last year, and a second to occur on February 29. The ECB refers to LTRO as a "non-standard measure," designed to alleviate severe credit conditions among the countries of the Eurozone.


Although LTRO is a European initiative, the reaction of US stocks has been nearly identical to the move that followed the signaling of QE II in August, 2010. QE II was not implemented until November of that year, but market participants date the initial impact of QE II to a speech delivered by Fed Chairman Ben Bernanke, with markets rising in anticipation of the program.  The chart above illustrates the reaction of the S&P 500 stock index to both programs.


Similarly, European stocks surged in reaction to QE II, with the DAX, for example, rising more than 15% during the three months following the Jackson Hole speech, and about 18% since the December 21 announcement of LTRO. The impact of these two initiatives has been felt on both sides of the Atlantic.

This summary provides an overview of the program, including what it is, how it works, who is affected, and what we may expect in terms of the second LTRO.

What is LTRO?

LTRO is the acronym for "Long Term Refinancing Operation," the term that describes a major financing method used by the ECB to provide liquidity to its member banks. Contrary to popular belief, LTRO has been in existence since the inception of the Euro in 1999, though the tenor of the program was generally restricted to refinancing of three months. Beginning in 2009, the ECB began conducting 12-month refinancing operations, also seen as a "non-standard measure."

How does the current LTRO differ from the original program?

Unlike traditional ECB LTRO, the LTRO instituted by President Draghi lasts for three years rather than several months, with the banks' option of terminating the financing after one year. In addition, and very importantly, the standards for collateral eligibility have been relaxed considerably, making it much easier for banks to obtain funding.

What is the purpose of LTRO?

LTRO eases credit conditions in the Eurozone in two ways:

(1) allows banks to borrow unlimited funds for three years, as long as the banks can provide eligible collateral; and

(2) assists banks in managing their "gap risk," that is, facilitates the ability of banks to match the tenor of their assets and liabilities. Prior to LTRO many banks were only able to secure overnight funding.

The ultimate goal of LTRO as stated by President Draghi is to foster loans to the Eurozone private sector in order to support employment.

How does LTRO work?

LTRO is straightforward: All member banks interested in participating may do so. Banks may participate as long as they provide eligible collateral as a pledge against the LTRO loan. Eligibility requirements are not set in stone, though generally securities must be A-rated. The process is largely electronic and automated, including a comprehensive list of eligible collateral that can be readily accessed in order to confirm eligibility.

Collateral can be pledged directly to the ECB, or alternatively, to the central bank of the country of the borrowing member bank, as a "temporary solution."  In other words, French banks are able to access LTRO funding by pledging securities to the Bank of France rather than directly to the ECB. President Draghi has stated that the "responsibility entailed in the acceptance of such credit claims will be borne by the national central bank authorizing their use." In so doing, the ECB reduces its risk and delegates credit authorization to the central bank of the borrower. This measure significantly widens the scope of eligible securities.

What are the collateral eligibility requirements for LTRO?

The ECB provides a detailed eligibility list by country, though this list is not comprehensive and has evolved over time. Collateral must have a second-best credit rating of single A, whereas previously a AAA rating from two agencies was required. A wide range of instruments is permissible, including bonds, loans, asset-backed securities, etc. At the press conference following the ECB's monthly meeting held on February 9, President Draghi announced that the ECB will further expand the list of eligible collateral.

What is the size of LTRO?

The LTRO program is unlimited in size, said to be "full allotment." The first tranche of LTRO was for EUR 489 billion. Of this amount, approximately EUR 296 billion consisted of the rolling over of previous short-term loans with the ECB. It is not yet known how large the second tranche to be announced on February 29 will be. Estimates have ranged from EUR 300 billion to over EUR 1 trillion.

How many banks took part in the first tranche of LTRO?

523 banks participated, alleviating concerns that banks that took part would be stigmatized as a troubled institution. However, there is some evidence that certain banks avoided LTRO for this reason.

What are the terms of LTRO loans?

As mentioned, there is no limit to the size of loans available, provided that member banks post eligible collateral. The tenor of LTRO loans is three years, although banks may terminate after one year. The interest rate charged to borrowing banks is based upon the average of the overnight rate during the loan period, currently 1%. Substitution of collateral is permissible as long as the substituted collateral also meets eligibility requirements. There is a "haircut" according to the type and quality of collateral; that is, the loan is somewhat smaller than the market value of the collateral. This haircut acts as a credit cushion to the ECB and central banks.

How does LTRO differ from the QE of the United States?

The Federal Reserve's QE program is conducted in the open market, rather than directly with member banks. Under QE, the Fed purchases bonds of higher quality (only AAA-rated mortgage bonds or Treasurys are acceptable), with no determined termination date. In addition to the goal of injecting liquidity (cash) into the system, the Fed has stated that it looks to lower interest rates through its purchases, especially those associated with the mortgage market, in order to stabilize the residential real estate market.

The primary purpose of LTRO is to stabilize the Eurozone banking sector by providing member banks with liquidity, particularly over the medium term. Additionally, since LTRO was initiated, the cost of borrowing of most of the countries of the Eurozone has decreased significantly. Although the ECB has not openly suggested that banks buy Eurozone sovereign debt to be used as collateral, French President Nicolas Sarkozy has encouraged the practice.  Such purchases may have contributed to the decrease in sovereign borrowing costs.

What are some criticisms of LTRO?

Critics charge that in conducting LTRO, the ECB and other Eurozone central banks are overly extending their balance sheets, while at the same time increasing their credit risk by accepting collateral of a quality lower than has been customary. Some are concerned that instead of reducing their balance sheet and credit exposure, Eurozone banks are taking on more risk by adding to their holdings of sovereign bonds of the "peripheral" (weaker) countries. Still others are concerned that LTRO will result in a decrease in the M3 money supply, since secured ECB lending is not included in that measure. A further concern is that banks will not use the funds to make loans to the private sector, and point to the recent rapid rise in overnight deposits at the ECB as evidence of this phenomenon.