LTRO: A Talf for Europe
ECB lets banks delever in orderly fashion; Bank bond issues might be scarce this year
The ECB’s Mario Draghi has eased funding fears for European banks
A dismal 2011 for European banks – when share prices were beaten down, earnings shrank and funding dried up – ended on an optimistic note when the European Central Bank supplied 523 banks across the 17 euro-member countries with €489.2 billion of three-year funding in its first long-term refinancing operation. This was towards the high end of expectations among analysts Euromoney spoke to in the week before the operation.
The sheer number of banks applying to use the scheme, which provides funding at around 1% against a wide range of collateral of varying quality, right down to single-A-rated ABS of residential mortgages or SME loans, suggests there is no stigma attached to using it.
A second long-term refinancing operation is scheduled for February 29 and the expectation now is that this too will meet strong demand from banks, with estimates ranging up to €1 trillion of liquidity being injected into the banking system across the two operations. "The LTRO might be so well taken up that you might see a substantial reduction in supply in [bank] senior debt," Demetrio Salorio, global head of DCM at Société Générale, tells Euromoney.
"Why was the ECB announcement so important?" asks Matt Spick, bank analyst at Deutsche Bank. "For the simple reason that although the banks have substantial deleveraging plans in the short term, there is a mismatch between the pace of deleveraging and the pace of funding rolling off."
The ECB has prevented the nightmare outcome of banks losing funding faster than they can shed assets. For banks, the benefit of having funding assured for three years is that it allows much greater certainty of planning as they now settle down to deleverage in a more orderly way than looked possible as the final quarter of 2011 drew on with funding markets still shut to most.
Some market participants fret that the sheer size of the operation – amounting to a 20% expansion of the ECB’s balance sheet into the largest among the world’s central banks, and exceeding the first and second quantitative-easing programmes of the US Federal Reserve – underlines the stress in the European financial system without addressing underlying sovereign and banking-system solvency issues.
However, for now, the sheer sense of relief that banks will not be brought down in the next six months by their inability to roll over wholesale market funding overwhelms remaining worries about European government’s capacity to re-order their budgets, improve competitiveness and restore growth by 2015.
The hope is that the ECB has broken the back of the banks’ funding crisis and by doing so laid a path for banks themselves and for other borrowers, including sovereigns, to maintain funding as they strive to improve their own credit fundamentals.
"It still doesn’t seem to be widely understood how important a positive the three-year LTRO is. I think of it as the European version of the US Talf " says David Knott, global co-head of FIC at Société Générale "where the central bank provides long-term funding at a much cheaper rate than would be possible in a stressed market environment". He adds: "The soft underbelly of the euro has always been the national banking system. A sovereign such as Italy can pay 7% for funding for quite some time and not cause a break-up."
Knott suggests the assured supply of abundant and cheap longer-term funding for banks might have knock-on beneficial effects for bank issuers in the private-funding market and for the borrowers that depend on banks.
Bond investors abandoned the banks last year due to fears over sovereign exposures, concerns over vast supply of new bank debt due this year and worries over regulation making it harder for banks to produce earnings. The ECB’s LTRO removes at a stroke concerns over funding supply, at a time when bond investors have gone underweight banks in expectation of large amounts of primary market issuance that might not now appear.
fall in Italian two-year yields between announcement and execution of LTRO
Relief was immediately apparent in the sovereign debt markets even before the LTRO was allotted on December 21. In the 13 days between its announcement on December 8 and the LTRO’s execution, yields on Spanish two-year notes fell by 87 basis points and on Italian two-year notes by 117bp, notes Phil Suttle, chief economist at the Institute of International Finance. With rates set to stay low in Europe for a long time, the desperate hunt is on for yield. That usually carries with it the risk of principal loss. For banks funding through the ECB at low cost, high yields on the short- or medium-term paper of struggling sovereigns now promising to put their finances in order might suddenly look more attractive. If banks now pile into a carry trade in bonds of governments that eventually default, then the ECB’s extraordinary measures could yet backfire.
Gary Jenkins, principal at Swordfish Research, notes: "One can understand a bank treasurer placing their three-year loan into six-month Italian debt but it is unlikely that they will want to take the volatility and default risk of 10-year paper. The exception to this might be the Italian banks, where they might as well be all in. After all, to a large degree their fate lies with the government."
In the short term, the carry trade promises a boost to bank earnings.
Spick at Deutsche Bank says: "We expect ECB funding provision to banks to comfortably exceed €1 trillion in Q1 2012. At a marginal funding cost of say 1%, and a margin of say 4%, arbitrarily, the carry benefit to net interest income for the system on €300 billion of incremental funding would reach €12 billion. If half of this accrued to our coverage universe and dropped straight to profit before tax, this would represent around 5% earnings uplift."
While the ECB’s LTRO offers banks almost unlimited amounts of cheap term funding against a wide range of collateral, it would be irrational not to take advantage. This might be the moment, Knott at Société Générale suggests, for banks to return to the senior debt markets, even if only in modest size, simply to signal their access to a wide range of counterparties. In the first days of January, banks launched a number of covered bonds. The next step is unsecured.
Knott says: "Banks will want to raise their deposit funding so they are less dependent on the short-term interbank market, but all banks must eventually be able to issue senior unencumbered debt in order to function effectively. If the LTRO is very effective, it might well facilitate the re-emergence of an unsecured funding market, as it can significantly reduce the amount of funding needed to be taken by banks from the private sector."
If the ECB succeeds in boosting demand for senior bank debt by creating an impression of scarcity around bank bonds, it will have worked a little piece of magic. But for this to translate into sustainable support for bank debt will require something more: a delay in bringing forward legislation around bail-in of bank bondholders would help, so would some de facto watering down of Basle III regulations.