Tyler Cowen tackles ECB questions that have been troubling me.
Everyone is happy that bond yields are falling, but what is the next step in the resolution of the crisis? Here is one report from the front, decide for yourself whether it is good or bad news:
Last week 800 banks requested €529.5bn of three-year funding under the European Central Bank’s longer-term refinancing operation, on top of €489bn borrowed in the first tranche of the LTRO in December.
The €1.019tn total is not far shy of the €1.106tn of European bank senior debt due to mature in 2012, 2013 and 2014 combined, according to Goldman Sachs, which said the “extremely high” injection of capital means “European banks are now effectively pre-funded through to 2014”.
Given that the ECB funding costs 1 per cent, compared to yields on senior debt of 3.5 per cent, some believe many banks will simply let much of their senior debt mature…
It would be an exaggeration to claim that the ECB has taken over European capital markets for three years, but you can see where my thoughts are headed. What happens when the three years is up, or as that time approaches? I see a few possible scenarios:
1. Banks recapitalize themselves with sound lending, and at the end of the three years they return to private capital markets by issuing debt. What would the new cost of capital be?
2. European banks continue to hover on the precipice for three years, and as expiration approaches the ECB renews its commitment to fund. (If the ECB funds the banks for six years running, at what point are the banks de facto nationalized? After how many years of ECB funding at one percent is it impossible to return to private markets?)
3. As expiration approaches, no one will be quite sure whether European banks still hover on the precipice, and so the ECB will implicitly signal a willingness to run another three years credit if the private money is not there. That will make the banks less interested in cleaning up and raising the private money. How are banks encouraged to reveal the true state of their market?
4. By the time the three years is up, a lot of these institutions will have been nationalized, if only de facto.
The Eurozone is now in a recession, with further financial shocks likely to come (more Greek problems, Portugal falling into receivership, Irish referendum, French election, slowdown in China, etc.) What is the probability that #1 comes to pass? I say below fifty percent. Just how bad is #2-3? What other options are there? How long would it take for de facto bank nationalization to lower the economic growth rate? How long would it take before re-privatization is an option?
By the way people, we’re exploring the best case options here, they did avert disaster in December! For now.
And do follow on to read Karl Smith.
Regular reader know my long standing policy advice that averting disaster for now – kicking the can down the road – is the essence of success. In part, I want to use this example to highlight why this makes sense.
(…) However, to Tyler’s ultimate question: “What is the end game”
I do think its to early for that. Right now we hold the line. However, what you want to see is two things
1) The unsecured interbank lending market to function smoothly and at the target rate.
2) The marginal return to capital to rise above the target rate.
Given the structure of the LTROs – should they continue – there would then be more hesitance to use them because there is no advantage and there are transactional complications.
If you can achieve the same funding unsecured overnight, and you have ample real demand there is no need to park collateral at the ECB. You pull whatever you financing you need out of the unsecured markets and then use your collateral to back more flexible liquidity arrangements, like Repos.
So, in a return to normalcy desire to use the LTRO just rolls off.
If that doesn’t happen, then well we have bigger problems which we need to deal with as they come based on how they actually manifest.