Monday, December 19, 2011

The ECB's XMas Present

I regard the new 3y Tender by the ECB (first one to be conducted this Wednesday and the next one in February) as an extremely positive development. The unlimited fixed-rate tender provides the banks with the option to redeem all or part of the acquired liquidity in 1 years’ time. Hence, banks keep flexibility over their collateral usage. More importantly, the ECB eased collateral standards (ABS down to A rating are eligible as are loans to small and medium sized enterprises).

I see the following main advantages of this tender:
1. During the next year a significant amount of bank bonds will reach maturity (around EUR 800bn). Approximately one quarter of this are government guaranteed bonds which were issued after the Lehman bankruptcy and carried an original maturity of around 3 years. Currently, banks face a very difficult environment to issue bonds (even for covered bonds) and most likely would need to revert to a new scheme of government guarantees. However, in those countries where even the sovereigns face a challenging environment to issue bonds, government guarantees would provide only a limited insurance function. However, as banks can now fund themselves for 3 years at 1%, this ECB tender should go a long way in easing the refinancing burden during 2012. It secures medium-term bank liquidity at a very low rate. Furthermore, it eases the pressure for governments as the likely size of needed government guarantees drops. Hence, via this tender, the liquidity provision for banks via sovereigns is being substituted by the ECB!
2. Banks can fund illiquid SME loans at extremely favourable conditions (1% at present). The drawback though is that the necessary legal paperwork so far has apparently not been finished yet and hence it is not clear whether this applies already for this week’s tender or only for the next one in February. This has several effects. For one, banks don’t need to fund these loans anymore in unsecured markets. Hence, it takes the pressure of unsecured funding markets. Furthermore, it increases the positive carry of the bank loan book as funding costs drop sharply. Finally, it frees higher-quality collateral which banks can use for other secured transactions.
3. The refinancing costs for Eurozone banks should fall sharply (as they fund an increasing part of their balance sheet at 1%). This increases realized margins and should help to restore equity over time, improving bank solvability.

I am convinced that the easing of banks’ funding pain is also behind the improvement in the short-end dynamics of the Eurozone periphery over the past week. Especially for small and midsized banks which a) are not part of the EBAs Stress Tests and b) hold large shares of SME loans, this tender should significantly reduce the need to deleverage and on the margin improve the demand for (domestic) government bonds, especially those that trade above 1% yields and mature in around 1-3 years.
Overall, I expect the two tenders to result in a very large take-up by Eurozone banks. However, it is likely that the February tender will be significantly larger given that so far the necessary legal paperwork for accepting bank loans seems not to be finalised yet. However, I do not think that this action is enough to break the adverse feedback loop and the real test will happen from around mid-January onwards, when the sovereign funding spree starts in earnest.

I wish all my readers a happy festive season and a good start for 2012!

Thursday, December 15, 2011

Financial Repression

I have been advocating that the ECB should be buying peripheral government bonds for quite some time (see Monetary easing in the wrong places or will the real ECB please stand up? dated 17 November 2010), however, that does not seem to be forthcoming. I have co-authored a research piece which proposes a different solution. It is based on the following:

1. There are no good solutions left
2. We are in the midst of a devastating debt-deflation spiral. While such a downward spiral starts with an insolvent borrower (in our case Greece) it also affects solvent borrowers and via the negative feedback loop (higher yields = higher deficit/lower growth = lower solvability = lower rating =higher yields) it ultimately destroys even the healthiest borrower (for every frequent borrower, there is a level of yield which it can not afford for a prolonged period of time).
3. What directly follows from the above is that we are in a state of multiple equilibria. One equilibria is the one where we are headed to now which will destroy all the sovereign borrowers of the Eurozone/the Euro. Another equilibria is if government bond yields can be lowered enough to restore fiscal solvability (via lower yields) and improve Eurozone bank balance sheets (via higher prices for government bonds).
4. Hence we need to find a very large buyer for Eurozone government bonds. If the ECB does not want to buy and the EFSF is not large enough (and remember as the EFSF has no banking licence, hence it needs to issue bonds itself to get cash before it can buy government bonds in the secondary market), then our solution is to use financial repression. More specifically, we would force banks to substantially increase their liquidity buffers over the next four years with only Eurozone public sector exposure allowed in this liquidity buffer. 
If complemented by a stability union, the prevention of further voluntary/forced haircuts on government bonds as well as the exclusion of Eurozone government bonds from further stress tests by the EBA then we are convinced that this will be able to break the debt-deflation spiral.