TLTRO effect is the ECB’s Waiting for Godot

September 23, 2014

AWhen banks are offered hundreds of billions of euros worth of what is essentially free money and they don’t take everything they can get, something has gone seriously wrong.

The European Central Bank’s latest offer of cheap cash to banks — only this time tied to loans they provide to private sector businesses rather than with no strings attached — has gotten off to a weak start.

That suggests not only that temporary liquidity for lending may be the wrong approach to boost a flat-lining euro zone economy that is barely generating any inflation, but it also underscores the much more serious lack of demand in the economy.

With only 82.6 billion euros taken up in the first of two tranches it is now clear that the ECB will not be able to find enough takers for the 400 billion euros it has put on offer.

The latest Reuters poll of euro zone money market traders predicts that banks will take up 175 billion in the December auction, leaving one-third of the cash untapped.

To put that number in perspective, when the ECB last offered money like this in the depths of the euro zone debt crisis a few years ago banks swallowed up more than one trillion euros. That made for explosive results on asset prices but also did very little to spur lending.  

Now ECB President Mario Draghi, who is running an institution that appears programmed to do everything in its power to avoid outright purchases of sovereign bonds as a policy option, is running out of room for manoeuvre.

Part of the problem is he’s spinning a lot of policy plates at the same time.

The latest round of cheap cash — dubbed Targeted Long-Term Refinancing Operations (TLTROs) — comes along with record low interest rates and an even more-negative deposit rate, which in theory should drive banks to take the cash and lend.

The ECB also plans to build up the Asset-Backed Securities (ABS) market in Europe in order for the central bank to swoop in and purchase vast swathes of it. 

That will be lucrative for those who want to sell on those securities, and some traders have suggested that waiting for details on ABS purchases has interfered with the TLTRO.

Either way, banks will need to expand credit in order to usher in a climate where securitisation — which involves parceling together new securities backed by loans against assets — takes place. The idea is to connect small and mid-size businesses with the broader capital markets, where large companies tend to go first to borrow.

But that underlying lending does not appear to be happening.

Lena Komileva, chief economist at G+ Economics, wrote:

In market psychology terms, it creates a dangerous market co-ordination loop between ‘buying’ the ECB announcement and ‘selling’ policy action, which threatens to disrupt the core channel of policy transmission into real economies – confidence.

In other words, so long as markets are just trading the effect from policy announcements but not actually responding to the policy, nothing will ever happen to real lending.

The ECB also is close to wrapping up a lengthy assessment of euro zone bank balance sheets and will have to walk a fine line reporting the results in order not to create havoc if they contain any ugly surprises.

So why won’t banks take free money in the meantime?

Komileva explains it this way:

The big difference between bank activities in financial markets and in real economies is the financial incentives and risk aversion. Lenders manage their cost of credit and capital more efficiently by selling securities to other investors and by borrowing from the ECB, whereas when a loan is made in the real economy it stays on the bank’s books until it matures. This is an expensive diet for capital-constrained banks. 

Lending to the private sector has been in decline for the better part of two years and shows no signs of abating since the TLTROs were launched in June.

The latest data from the ECB due on Thursday are expected to show a 1.5 percent annual decline in lending, according to the latest Reuters poll, barely changed from the month before.

Economists appear to be paying very little attention to this data series, making no visible attempts to establish the link between whether a revival in private sector lending might generate any significant amount of inflation. 

Either way, one thing is clear.

If a central bank offered hundreds of billions of euros worth of cheap cash directly to individuals, there wouldn’t be much humming and hawing over whether or not they’d take it.

And the sudden explosive demand for goods and services that would most certainly follow from such a massive infusion of cash in a climate where saving it pays you less than nothing would almost certainly spawn a powerful rush of inflation.

For now, we wait for the lending to pick up.

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