March 13, 2012

End-February, the ECB provided banks with EUR 530 bn of liquidity for three years via its longer-term refinancing operations (LTRO). As with the first three-year LTRO in December 2011, the provision of liquidity is designed to avert tensions over bank lending. The first three-year tender has also had an effect on European government bond markets. As mainly Italian and Spanish banks increased their exposure, yield curves for Spanish and Italian bonds shifted downwards at the short end.

On February 29 the ECB provided 800 banks with EUR 530 bn of liquidity for 3 years via its longer-term refinancing operations (LTRO). For the tender the banks have to pay a variable interest rate that is based on the average main refinancing rate for the period concerned. This figure is currently 1%. As with the first 3-year LTRO already held on December 22, 2011, in which 523 banks took up EUR 489 bn, the provision of longer-term liquidity is designed to avert tensions over lending especially in the countries currently facing problems (GIIPS). Because of the debt crisis many commercial banks in the euro area are unable to obtain sufficient refinancing either via the interbank market or the capital market and are obliged to take up ECB refinancing.

A fraction of the longer-term liquidity taken up was used to redeem shorter-dated refinancing operations, which means that the additional liquidity supplied is smaller than the total amount. In December 2011 the additional net volume was around EUR 190 bn and in February 2012 it probably came to about EUR 315 bn. The ECB has thus boosted the volume of its refinancing operations to EUR 1,130 bn (as of March 2, 2012) and has almost doubled them since mid-December.

An analysis of the data at the national level shows that in particular Italian and French banks, but also German and Spanish banks have tapped the ECB’s refinancing facility (Also foreign affiliates of the banks may tap the refinancing facility at the national central bank.). The banks then reinvested a large proportion of the additional liquidity with the ECB in the form of short-term deposits. As of the end of December 2011 – i.e. following the allotment of the first LTRO – short-term deposits had thus increased by a good EUR 200 bn to more than EUR 400 bn. It was German and French banks in particular that boosted their liquidity reserves. In the meantime short-term deposits at the ECB exceed EUR 800 bn. Banks thus have access to a cushion to ease future refinancing problems, which could also help them to provide loans.

The first 3-year tender has also had an effect on the European government bonds held by the banks. After considerably reducing their exposure between October 2010 and November 2011 – as a consequence of the uncertainty caused by the sovereign debt crisis – banks have again increased this exposure. Since the end of 2011 the banks had increased their holdings of European government bonds by more than EUR 50 bn to EUR 1,448 bn in January. The net buyers were almost exclusively Italian and Spanish banks (see Chart 2), whose holdings at the end of January were EUR 280 bn and EUR 230 bn respectively. Banks in these countries have mainly acquired government bonds issued by their own country. By contrast, banks in Germany and France barely increased their holdings of European government bonds. They had already reduced their exposure between October 2010 and November 2011 by EUR 110 bn and EUR 140 bn respectively.

In line with this development the yield curves for Spanish and Italian bonds have shifted downwards at the short end (see Charts 3-4). In Germany and France no comparable shift has been discernible – probably also because of the relatively small yields on short-dated paper which make a carry trade of the above-mentioned kind unattractive. Banks in Spain and Italy that already have large holdings of government bonds on their books should actually find it easier to park their additional liquidity in government bonds. However, the prospect of price and interest gains may have been accompanied by the potential risks of this position being ignored as the banks expect to receive government support if the worst comes to the worst.

Following the decline in risk premia and increased demand for government bonds the ECB has scarcely been compelled to make support purchases via the SMP scheme since the first LTRO. The expansion of refinancing operations could thus be regarded as a substitute for direct intervention in the market and as indirect deficit financing via the ECB. One important difference, though, is that the risks attached to government bond purchases are not borne by the ECB but by the commercial banks. It is probably also no coincidence that the ECB only decided to expand its refinancing operations after far-reaching resolutions were approved at the EU summit in early December.

In taking this step the ECB kills two birds with one stone: firstly, it ensures the supply of liquidity to the banks; secondly it brings about stabilisation of the situation in bond markets without increasing its direct exposure to sovereigns. The ECB is thereby also sending a signal to the politicians. It is prepared to continue supporting the political process in Europe, as long as tangible progress is being made. Now, however, it is up to governments to bring about further stabilisation and to use the time they have bought to implement the necessary structural reforms and consolidation of government finances.