Opinion

Felix Salmon

Explaining the ECB’s latest program

By Felix Salmon
October 7, 2011

The ECB announced yesterday that it’s going to be throwing a bunch more cash at European banks. No one knows how much it’ll end up being, exactly, but it’ll almost certainly be in the hundreds of billions of euros.

The commentary on the decision, some of it very good, can get extremely technical extremely quickly. And so, at the request of Nick Rizzo, here’s a quick English-language explanation of what’s going on.

At heart, what the ECB is doing is very simple: it’s lending money to European banks for 12 or 13 months at low interest rates.

If you’re a European bank, that money is attractive, because many banks, especially ones on the European periphery, are finding it hard to borrow money these days.

This is not a bank recapitalization plan — it injects no new capital into Europe’s banks. If those banks are facing solvency issues, then this program — known as LTRO — is not going to help on that front. And right now, in the wake of Dexia’s fall, markets are worried again about bank solvency. (And as Intesa Sanpaolo unhelpfully pointed out in its own defense, Dexia aced the Eurozone stress tests.)

But it’s a great relief to banks facing funding difficulties to be able to lock in one-year money at low rates. For 12 months from October 25, or 13 months from December 21, they’ll be able to have a large sum of money without having to worry about rolling it over.

But there’s the rub — there’s no indication from the ECB that it will offer to roll over these funds at all. On November 1 2012, or January 31 2013, all the borrowed money has to be repaid to the ECB, with interest.

So the banks borrowing this money are unlikely to turn around and lend it to small businesses on a five-year term, or otherwise use it to increase lending and boost the real economy. Instead, they’re much more likely to invest it in bonds which carry a decent yield, especially from Spain and Italy. Because those bonds yield somewhere between 2.3% and 4.4% — significantly more than the cost of the ECB funds — the banks should be able to take their ECB money, invest it in short-dated Spanish and Italian debt, and get a comfortable yield pickup along the way. For instance, suppose you buy an Italian bond yielding 3.9% which matures in December 2012, while borrowing money from the ECB at 1%. Put €1 billion into that trade, and you make a profit of €29 million.

The ECB is happy about this, because it helps to support the price of Italian and Spanish debt. But there are definitely risks here, too. For one thing, especially since the Moody’s downgrade, Italian and Spanish debt ain’t what it used to be. Once upon a time, short-dated bonds from Italy and Spain were pretty much as good as cash, for European banks: any time they needed immediate liquidity, they could just swap their bonds for cash in the repo market. But no longer — counterparties are increasingly wary of accepting that paper as collateral, especially given how volatile it can be in price terms.

And of course if the banks step in to buy lots of Spanish and Italian debt now, maturing at the end of 2012, there’s a huge question as to what happens then. Neither Spain nor Italy will default next year. But in a year’s time, people might well start worrying about where those countries are headed, if the Eurozone continues with its muddle-through approach to the crisis.

The ECB, then, is kicking the can down the road — which is exactly what it should be doing, if the problem in the European financial sector is mainly a liquidity problem. Liquidity problems go away over time.

But if you think there’s a huge solvency problem in Europe, can-kicking has a tendency to cause more harm than good.

Comments
One comment so far | RSS Comments RSS

One question which I repeatedly return to:

How does government financing through the fractional reserve banking system on unlimited tender money from the ECB differ from government financing by the ECB itself.

Is Basel II, 0 Risk weighted capital for sovereign debt and the fractional reserve system at the heart of all problems?

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