In recent days, the ECB has started to pay closer attention to the fact that the monetary transmission mechanism of its interest rate policy is quite broken in the case of the periphery, making its rate cuts ineffective. The problem stems from the fact that both its own financing operations as well as general interbank lending is done through the repo market (in the case of the interbank market there is also the unsecured market although that is shrinking, especially for periphery banks). As a result, volatility in collateral values (either that posted on ECB operations or in private repo loans) plays a major factor in the effective repo rate (after margin calls are covered). Moreover, high volatility collateral leads to higher haircuts (so that the lender is safe from a large price move in case he had to liquidate his collateral) while periphery counterparty risk (undercapitalized banks with large NPLs and risky assets) leads to higher general repo rates.
Another factor is the large Target2 liabilities which are financed by central bank lending and increase the effective ‘liabilities cost’ of banks.
In such a context, rates will not be transmitted efficiently in the case of banking systems with high volatility collateral. The obvious solution is to lower volatility which can happen in two ways:
- Use credit claims as collateral which do not face daily mark-to-market although they are subject to large initial haircuts (making the effective loan capacity lower). The LTROs used such a framework by relaxing collateral rules on eligible credit claims (and also accepting government guaranteed bank private bonds).
- Lower the volatility of securities used as collateral which requires a buyer of last resort (a role that was played by the SMP portfolio and might be taken over by the EFSF/ESM).
Based on the above one can reasonably assume that further rate cuts by the ECB are not in the agenda until the transmission mechanism is fixed. That would necessarily involve some combination of relaxed collateral rules and a secondary market securities purchase mechanism (SMP or EFSF/ESM). The open question is if such a move would be enough to lower counterparty risk and increase private repo turnover/lower euro outflows from the periphery or if it will lead to the ECB being an even larger market maker.
For now interest rates on new loans (up to €1mn) to non financial corporations with maturity higher than 5 years are quite different in the periphery compared to Germany, although they should include significant local macro risk in the case of the periphery: