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Since the second 3Y LTRO matured this week while the ECB QE starts in a few days it is interesting to take a quick look at the overall liquidity position of the European banking system. According to the latest Eurosystem weekly statement, lending through regular refinancing operations (MRO and LTROs) was €501.3bn during the preceding week (this does not include the sizable ELA lending of Greek banks which appears to have increased by €5.6bn).

Based on the outstanding OMOs, total lending now stands at €488,3bn. A large part of the maturing 3Y LTRO was replaced by higher MRO lending (which increased to €165.35bn from €122.11bn in the previous week) yet overall financing was €13bn lower and now stands at less than €500bn. In other words, total bank financing is now close to the allotted amounts of each of the two 3Y LTROs (first: €489.2bn, second: €529.5bn).

Obviously the European banking system has lowered its reliance on Eurosystem financing substantially. It seems that any increase in the Eurosystem balance sheet will only be the product of outright purchases through the ABSPP/CBPP3 and government bond program. It is even probable that individual banks will use the newly created reserves in order to reduce their reliance on Eurosystem financing and free encumbered collateral which will result in lower MRO allotments in the next few weeks. Consequently, one should observe almost immediate effects on repo market rates and turnover by the upcoming ECB QE purchases.

Taking a look at recent ECB term deposit rates (the 7-day term deposits used to sterilize SMP liquidity) one will observe that rates have expanded somewhat from 1bp to 4-5bp (the latest auction settled around 5bp):

ECB SMP Term Deposit Rate

Total amount of bids has also fallen below €300bn (with SMP liquidity around €206bn). This indicates that overall excess liquidity has fallen considerably (based on the term deposits auctions to lower than €100bn) and is pushing short-term rates higher. This is reflected on overnight repo rates with the Eurex GC Pooling EUR Funding Rate climbing to 4-5bp. LTRO repayments and lower Target2 balances have started having an impact on money market rates. The latest auction only had €254bn in bids and is a good indicator of available funds in the Euro money market.

Falling excess liquidity will start pushing money market rates closer to the cost of funds (currently 75bp). Unless the latter is lowered by the ECB it is possible that money market lenders will start avoiding long repo maturities and focus on short-term deals (overnight/weekly). It also points to a higher probability of an ECB rate cut in the immediate future.

Today, the ECB decided to lower the MRO, marginal lending facility and deposit facility rates by 25bp to 0.75%, 1.50% and zero.

When trying to evaluate the possible results of today’s decision, one should bear in mind that the European banking system (and money market) is segmented. One part consists of core banks (German, Dutch) with large amounts of excess liquidity in the deposit facility while the other includes periphery banks with low levels of liquidity which sometimes have to use special refinancing facilities such as the ELA in order to cover settlement of (mainly inter-European) transactions. The flow of funds is not uni-directional but only flows from the periphery (bond maturities, deposit outflows, capital flight) to the core.

As a result, in general the periphery bears the cost of borrowing funds (at the ECB MRO rate since it does not really have access to the money markets), while the core uses the deposit facility to earn a risk-free return and/or invests funds in low-risk collateralized repo transactions. With that in mind, today’s MRO rate cut can only be positive since it will lower the cost of funds for (troubled) periphery banks, either through regular refinancing operations or ELA.

On the other hand, the elimination of the deposit rate marks the loss of strict control over the money market rates by the ECB (which started with the introduction of  the 3Y-LTROs). Ever since the 3Y-LTROs, excess liquidity pushed repo rates to extremely low levels of a few bp. Now, rates are only limited by the zero bound. Moreover, arbitrage opportunities between the deposit facility and the repo are now over, lowering the incentive for market making by large banks which helped the non bank money market participants (who did not have access to the deposit facility). Banks could bid for funds and deposit them at the ECB earning a spread and increasing the money market turnover, price discovery and maintaining low bid-offer spreads.

Now, the only risk-free return offered by the ECB is the weekly SMP term deposits, which will surely see new lows in rates and large offered amounts. Compared to a deposit facility of €800bn, term deposits of €210bn are rather small and auctions will become ‘crowded’.

Current (5/7) annual eurepo rates are 0.07% (offer rates are reported). In other words, a repo of 1 million Euros will only provide a return of 700€. Assuming a bid-offer spread of just 1bp, the return of market making will be only 100€ (on €1mn) and probably not even cover transaction costs, especially since most trades are for very short tenors. A market participant facing such low returns for large trades will only be rational to demand collateral of the highest quality possible. These numbers point to a strong decrease in market turnover with the European market ‘turning Japanese’. Given the high risks involved in the European money market, the most possible scenario is that participants will opt for principal conservation and only look for very low risk assets, pushing their yields even to negative territory (something that has happened with short-term German paper).

Financial institutions other than banks are almost as large as the banking sector in the Euro area:

These investors had the alternative of investing in the (secured/unsecured) interbank market for short tenors. A pension fund (and other investors) could loan available funds in the repo market for one month (in return for high quality securities), rollover the loan for 3 months (to the same or other counterparty) and earn an annualized rate of over 0.12%, which was much higher than rates on German 3-month T-Bills:

Now such trades are not available. Coupled with the fact that new securitisation issuance in the Euro area is limited (the 3Y-LTROs were mainly provided in order to allow previous securities to mature since new issuance was not possible), as well as the supply of safe assets, most short-term safe assets will see their yield turning negative very quickly.

Also, given the fact that the Fed pays 0.25% on USD bank reserves, banks with access to both deposit facilities should prefer USD in terms of risk-free returns.

The ECB probably expects more risk taking from its move today. In my view the result will be a decline of trading in the interbank market, negative yields and lack of profitable low risk trades. Providing the banking system with zero low risk returns is not a recipe for risk taking but rather for making the market smaller and less efficient.

In a sense, cash and bank reserves (at least those kept in the deposit facility) now have the same zero rate of return. They only differ in transaction and storage costs. I don’t see how making banks indifferent between holding cash or bank reserves (with the first basically only capable of settling small transactions with the public) is a monetary easing action.

Update 6/7: And here’s today’s eurepo rate curve. Rates for tenors longer than 2 months are under 2bp (although that is a product of averaging, actual rates are quoted in two decimal places). So the bid-offer spreads should be around 1bp with returns of 100€ for a €1mn trade. A number of participants are now actually quoting negative rates.

Eonia swap rates have also dropped significantly, while euro money market mutual funds have started denying new cash and short-term German T-Bills are dropping to strong negative yields.

During the last few days, eurepo rates have been increasing, especially in very short-term maturities:

* source

In my view this increase can be attributed to:

  • Lower excess liquidity in periphery banks (especially Spanish/Italian ones) which pushes them to higher use of MRO lending (as is evident in recent ECB weekly statements). Since the MRO rate is paid on the operation maturity (MROs are weekly operations), the banks cost of funds is higher (compared to the LTROs) which pushes their offered repo rates to higher levels.
  • Capital flight from the Eurozone as a whole which mostly moves to Swiss banks. The latter could probably have tighter lending standards and require higher compensation for their borrowing in the euro repo market. Furthermore, any euros acquired by the SNB (as part of its swiss franc floor policy) will probably be parked at the ECB (or maybe invested in German debt) and not lent in the interbank market.
  • General risk avoidance (especially given the ongoing rating downgrades of European banks) with a shortening of repo maturities and higher repo rates (to compensate for higher risks).

Luckily, the EBF also provides detailed daily rates per panel bank which seem to confirm the above hypothesis:

The increased rates from ING are a bit worrying. It’s also quite evident (especially if one looks at the total panel bank data) that there’s a visible increase in both the ‘risk-free lending rate’ (which is probable around 0.15%) as well in the troubled bank premium (which offer rates close to 0.20%).

Bank of Spain released its balance sheet for May today. The basic observations are as follows:

  • Target2 liabilities continued to increase growing to €318.6bn, a change of €34bn in a month. On the other hand, the deposit facility dropped further to €36.8bn.
  • Lending from the ECB increased in May through the MROs (which closed at €9.2bn compared to €1.8bn in April) while the LTRO remained unchanged.
  • Government deposits dropped from their high level of €24bn to €11.2bn.

Overall it is clear that capital flight is steady at around €30bn/month. Spanish banks excess liquidity (acquired through the 3Y-LTROs) has dropped to alarming levels, while the MRO borrowing shows that the banking system is already facing liquidity problems. Furthermore, the government deposit position is now low and cannot function as a balancing factor.

If this level of capital flight continues in June as well, Spanish banks will need to use short-term MRO lending from the ECB to cover the liquidity leakage. Bank of Spain daily interbank rate statistics point to very limited and expensive (especially compared to eurepo rates) access to interbank lending and only in very short maturities (overnight for unsecured lending, one month for repo loans). The recent increases in MRO usage visible in ECB’s weekly statements might be a result of Spanish banks lending.

As far as the Spanish banking system is concerned, a third 3Y-LTRO is quite needed by now.

On the Italian front, Bank of Italy released data on Italian debt. Table 5 contains details of holdings of securities by sector:

Although the data does not contain the most recent monthly details for all categories it is quite evident that, especially after the 3Y-LTROs, domestic MFIs were the main buyers of government securities, coupled with other financial (Other residents did the same in the second half of 2011). On the other hand non residents continued their exodus from Italian debt which amounted to €95.8bn during 2011 and another €24.6bn in the start of 2012.

Unfortunately, data for non residents only reaches February but an extrapolation clearly shows that resident MFIs/financials probably only managed to match outflows from non residents. Judging from the recent increase in Italian yields they aren’t successful any more.

Overall, the data point to a stressed environment but they aren’t recent enough to draw clear conclusions.

Following the release of Bank of Italy balance sheet for March, Bank of Spain released the same data today. In this case, the main points to be made are:

  • Banks increased their net lending from the Eurosystem by EU146.5bn to EU316.3bn. The increase came from new LTRO lending of EU163bn and a drop in MRO lending to the (negligible) amount of EU1.0bn (down from EU17.5bn) making all lending long-term. Total central bank credit of EU316bn is now a substantial percent of the Spanish banks holdings of securities (EU620bn in February), even if  Bank of Spain accepts collateral at par (which it does not). More than 50% of bank securities holdings are now parked in ECB although a substantial amount of collateral pledged probably is performing credit claims.
  • Net liabilities to the Eurosystem increased by EU55.2bn to EU252.1bn. In total, Spain and Italy now account for more than EU520bn in Target2 liabilities (an amount equal to net liquidity created by the two LTROs).
  • The deposit facility increased to EU88.7bn marking a healthy liquidity position (although with a substantial cost due to net lending (in contrast with German banks which increase their deposit facility holdings due to increased net claims to Target2).

The difference with Italian banks which used the LTROs only to finance their negative position with Target2 is significant. Spanish banks keep a large buffer of almost EU90bn in their bank reserve accounts which can cover carry trades and increased Target2 needs for the next months. The troubling fact is that probably most of their tradable assets are now posted long term on Bank of Spain balance sheet (which is a senior creditor) making it hard to find finance in the secured and unsecured money markets. The fact that Spanish banks hold such large amounts on excess liquidity makes the recent increase in Spanish sovereign debt yields rather strange, since that should provide an opportunity for an easy carry trade.

On a related note, Bundesbank also released its Target2 claims for March, which increased by EU68.6bn to EU615.6bn. This is clearly an unsustainable path, especially since on November (before the 3-year LTROs), Target2 claims were EU495.2bn, an increase of more than EU120bn. Almost 25% of the LTROs was used to finance transfers to the German bank system in just 4 months time. The latter should now probably be in a position to basically not need financing from the Bundesbank which might be obliged to provide liquidity absorbing facilities (term deposits, debt certificates) soon. Otherwise, short-term money market rates in Germany will fall to the deposit facility rate, marking significant monetary easing for the Euro core.

Such capital movements (and differences in lending costs and collateral value) make it quite clear that the Eurosystem will face a very stressed situation in the coming months. ECB action will be needed, either in the form of another LTRO or sovereign bond buying (which since the Greek PSI rather complicates than helps the situation).


If one were to extrapolate based on Germany’s Target2 claims data for 2011 and 2012, the best fit would be a polynomial curve pointing to a surplus of over €1tr at the end of 2012. Obviously such trends are clearly unsustainable:

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One of the reasons that an averaging provision exists for banks required reserves during a maintenance period is that it stabilizes the money market interest rate. In the words of the ECB:

The averaging provision implies that institutions can profit from lending in the market and run a reserve deficit whenever the shortest money market rates are above those expected to prevail for the remainder of the maintenance period. In the opposite scenario, they can borrow in the market and run a reserve surplus.

Banks run deficit/surplus in their reserve accounts to take advantage of the averaging provision
(the recent drop represents the ECB lowering reserve requirements)

It seems that the latest 3 year LTRO’s might allow a similar smoothing scenario to occur in the EOINA rate for longer periods. The latest MRO (7 day refinancing operation) was less than 30 billion € while the rest of the banks liquidity is provided through long-term LTRO’s, with more than 1 trillion € corresponding to the 3 year LTRO’s and most of the remaining amount in 1 year LTRO.

The problem is that interest on the refinancing operations is paid on the operation maturity. With MRO’s payments happened every week while the rest of liquidity was provided through medium term LTRO’s (1 and 3 months maturity). That made the MRO rates quite ‘sticky’ since banks had to earn most of the interest quickly in order to be able to pay it on operation maturity (the 2011 MRO’s were usually quite large in size).

Now almost all of the interest will need to be paid in more than a year from now, allowing banks to play averaging games with EONIA. Since liquidity is basically an asset of ‘Euro-core’ banks (which try to find risk free places to park it, lowering the SMP term deposit rate close to the ECB’s overnight deposit rate and basically only loan among themselves), the combination of excess liquidity and low needs to earn interest fast, works to push the EONIA to even lower grounds and remove spikes (the drop of required reserves to 1% from 2% also helped since the spikes occurred on the last days of each maintenance period) since the first 3Y-LTRO:

EONIA rate

On the other hand, periphery banks have to borrow using low quality collateral (something which increases the effective lending rate) from ECB, while certain banks (like Greek banks) have to use the ELA mechanism and borrow (probably) at 3.75% (and an effective lending rate of close to 4-5%). The end result is that ‘Euro-core’ has an ‘accommodating’ monetary stance with low lending rates and excess liquidity, while the periphery faces an effectively ‘restrictive’ monetary stance while it needs exactly the opposite.

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Kostas Kalevras

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