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Since I recently submitted my MSc in Finance dissertation titled «The informational content of SMP deposit auctions in forecasting short-term repurchase agreement interest rates», I would like to take the opportunity to write a few words on its conclusions. The main objective of the research was to examine whether SMP deposit auctions carried valuable information for forecasting short-term repo rates. Since banks with excess liquidity always faced the choice between parking their reserves at the weekly term-deposits for a week or lending them in the GC repo market, SMP deposit rates should act as an effective floor on risk-free money market rates.

In order to evaluate the above hypothesis the paper first suggested a stochastic model for the bid rate in auctions (based mainly on the level of excess reserves in the system) as well as the conditional variance of the bid rate process (the calculation suggested that the variance was not steady but a function of excess reserves therefore implying that a possible econometric specification would face heteroskedasticity problems).

The econometric specification used a cointegrating relationship between the weekly GC and SMP deposits rate in a VEC model also containing excess bids, number of bids and the VIX index (as a proxy of market stress) as explanatory variables. A competing VAR model of the MRO and GC rate was estimated and out of sample forecasts of the GC rate for the two models were compared. The results clearly indicated that the SMP deposits did provide significant informational content for short-term money market rates.

A few people might find the (very) large section in monetary policy and repo market details informative and helpful. Overall the paper is quite technical but I hope relevant for evaluating the effectiveness of certain sterilization tools used by central banks in recent years. It might prove useful in analyzing related facilities used by the Federal Reserve (such as Interest on Reserves and the overnight and term reverse repo facilities), a topic that interests myself as well.

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.

Since it’s been a few months since I took a look at periphery NCB balance sheets, it’s time to examine trends during 2013.


Spain seems to be the one driving overall Open Market Operations (OMOs) usage down:

BDE balance sheet Mar 2013

Since December, OMOs have declined from €357.29bn to €270.94bn (-€86.35bn) with 80% attributed to a fall in LTRO usage. It seems that Spanish banks are confident to repay a significant part of their LTRO borrowing from the ECB which, given the low interest rates of LTRO funding and the relaxed collateral rules, imply that market conditions have improved strongly. During the same period, the consolidated Eurosystem OMO funding to European banks has dropped €225bn which means that Spanish banks account for almost 40% of the relevant fall (with another large part accounted by French and German banks).

Looking into the balance sheet at more detail, one observes that use of the deposit facility was €44.2bn in December and only €10.94bn during March, reflecting much lower safety buffers for Spanish banks. This is linked to the drop in Target2 liabilities, from €352,4bn in December to €298.3bn in March (-€54.1bn). Still, liabilities continue to be high, almost 28% of Spanish GDP although they are much lower than their maximum of €428.6bn in August 2012 (a fall of €130.3bn).

The drop in Target2 liabilities is related to the increase in non-residents government debt securities holdings, with registered holdings increasing €30bn since October, from €209.6bn to €240.4bn in February (an almost 15% increase).

Overall, credit conditions have clearly eased during the last few months. Nevertheless, both the situation in the real economy and current NPL figures point to large risks ahead for the Spanish banking system. Spanish banks will probably keep low quality collateral (such as credit claims) parked at the ECB and only use high quality securities in order to borrow in the repo market at low interest rates   (since current repo rates are close to 0.02-0.03%).


The Italian case seems to be a bit more muted than Spain. Since December, bank borrowing from the central bank of Italy has dropped only marginally from €271.8bn to €268.2bn with a somewhat larger fall in LTRO usage from €268.3bn to €262bn. This is mainly explained from the fact that Target liabilities only dropped from €255.1bn to €242.9bn. It seems that Italy has decoupled from Spain, probably due to the results of the recent national elections and the inability to form a stable government as well as the fact that government debt figures are moving close to the 130% GDP figure.

This is also reflected on the general government debt statistics which illustrate the fact that non-residents holdings of securities have been extremely steady during the last few months and are much lower than 2011 figures.

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:

  1. 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).
  2. 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:

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%).

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Kostas Kalevras

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