In order to assist the banking sector in the Euro-area, the European Central Bank (ECB) introduced a 3-year Long Term Refinancing Operation (LTRO) in December 2011. The cost of finance for the 3-year facility was set at 1%. In addition, the list of collateral accepted from banks by the ECB was significantly expanded. In total, 523 banks utilised the LTRO, taking-up a total of €489 billion.
Following the introduction of the facility, the European banks have deposited record levels of cash with the ECB, earning just 0.25%. These deposits reached a new record high of €528 billion on 17 January 2012 (see chart attached), resulting in some criticism of the LTRO facility. The surge in deposits could mean that the problem is not a shortage of liquidity within the banking system, but rather a shortage of trust reflecting an extremely high level of counterparty risk aversion among banks.
Recently, however, the ECB highlighted that the banks depositing the money in the overnight deposit facility were not the same banks that were borrowing in the 3-year LTRO – it is hard for us to judge if that is true.
More importantly, according to the ECB, the amount borrowed by individual banks corresponds very closely to the amount of debt they have maturing in Q1 2012. If this is true, then it means that the problem of the €240 billion Euro-area bank debt maturing in Q1 2012 is no longer a major concern. In other words, banks will not be forced to issue new debt at higher yields to refinance their maturing debt and, furthermore, they have a 3-year window to manage their liquidity.
This also means that the investors who own the bank debt that matures in Q1 2012 will have to find a place to re-invest €240 billion. They could look at the EFSF, but that is offering only 0.22%, alternatively Germany recently financed 6-month money at a negative yield! In contrast, Spanish 10-year bonds are yielding over 5% - certainly an intriguing investment choice. Overall, despite the criticism, the LTRO was a very clever move by the ECB.
The ECB has also indicted that the next tranche of the LTRO will be offered on 29 February. This is likely to also result in a substantial allotment to the banks, since the ECB will allow the Euro-area banks to use their loan books as collateral (now that is a little scary). The Euro-area banks have a total of around €600 billion maturing in 2012. It is feasible that the banks could borrow this whole amount from the ECB (using the LTRO), which would leave existing bond investors with €600 billion to re-invest. Ultimately this may help to keep to sovereign bond yields under control. The Italian 10-year bond yield has recently traded down to 6.25%.
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