27 January 2012

ECB’s Plan for Bailing out Eurozone Banks

On 24 January 2012 IMF published the World Economic Outlook (WEO) Update with the significantly downward revised projections since the September 2011 forecasts, especially when it comes to euro area (2012 GDP growth: -0.5% vs 1.1% in September, i.e. 1.6% downwards). In some sense, the accompanying Global Financial Stability Report (GFSR) Market Update sounds even gloomier: the euro area debt crisis has intensified further, urgent actions needed to prevent highly destabilising outcomes. First of all, the European Central Bank (ECB) is under major pressure for doing something (read: for printing more money faster). Despite of the (sensible) opposition from Germans, the ECB is more and more doing what the markets are expecting it to do. Even more: it finally seems to have a plan (how good or bad, is another question). Let’s take a look.

For quite some time, the main “headaches” of the European policy makers have been:
1. Fragile banking sector, which has generally been “running” on very low levels of capital and liquidity, and thus extremely sensitive to the market sentiment, and
2. Weak public sector finances and indebted governments in general, but especially those of Greece and the other so-called PIIGS countries.

These two are “feeding” back into each other, and causing the so-called adverse feedback loops with the financial markets and the rest of the economy. A la: banks need to deleverage in order to strengthen their capital positions, and thus are restrictive in their lending activity; households and businesses are acting carefully and increasing their savings ratios (uncertainty about the future), more defaults in the real economy (collapses of the businesses that rely on short-term financing, no demand for certain products and services etc.; increasing unemployment); as a consequence, the revenues of the governments are lower, expenses difficult to cut, and debt and budget deficits increasing; loss of confidence in the financial markets, which is resulting in even more liquidity problems, unsustainably high interest rates and so one; weaker governments are not able to back up their banking sectors; even less confidence, even less credit, even more problems. (Indeed, only try to model this Ponzi scheme of debts!)

That’s more-less what has happened so far and what is still happening in the eurozone. That’s the explanation (although simplified) behind the IMF’s warnings. Right now, the ECB is aiming the following (even if not articulated this way):
* Making banking sector stronger in terms of improved capital and liquidity ratios while minimizing the need for direct capital injections or purchases of bad assets by the governments (which may even not have money for this)
* Securing market for the government bonds, incl. most critically those of Italy and Spain, and some other (core) eurozone countries
* Securing continuing credit flows to real economy (i.e. that the banks would not cut back lending to businesses and households when trying to deleverage their balance sheets)
* Re-gaining the trust of the market participants to the eurozone banks and governments
All of these goals need to be achieved at the same time, not just one or two.

Here is how the ECB’s plan is intended to work (or more precisely, how it looks to an outsider-observer).

First, ECB guarantees essentially unlimited liquidity to the banks in the form of cheap loans. The Governing Council of the ECB announced rather sizable measures already on 8 December 2011:
* “To conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months and the option of early repayment after one year” – this basically means three-year fixed rate loans at ca. 1% interest rate (of course, the banks must provide eligible collaterals for these loans; however, the range of collaterals was increased too, see below);
* “To reduce the reserve ratio, which is currently 2%, to 1% as of the reserve maintenance period starting on 18 January 2012,” – in other words the eurozone banks have to hold two times less cash reserves than normally (higher reserve ratios and stricter liquidity rules are not necessary, given the unlimited liquidity from the central bank, right?), i.e. the money multiplier (the maximum amount of commercial bank money that can be created by a given unit of central bank money) has increased from 50 (1/2%) to 100 (1/1%);
* “To increase collateral availability...” – i.e. eurozone central banks can now accept a wider range of collaterals from banks, incl. ABS-s (Asset-Backed Securities) the underlying assets of which comprise residential mortgages and loans to small and medium-sized enterprises (SMEs).
Plus of course, low key interest rates.

Secondly, banks are supposed to use this cheap central bank money for continuing their normal business activities. Here is at least one “but”: many banks need to improve their capital ratios by the end of June 2012, as requested based on the result of 2011 EU Capital Exercise. Yet there is a solution too: certain assets are assigned zero risk weights, i.e. no capital is needed for them. Among others, such assets include exposures to eurozone member states’ central governments and central banks denominated and funded in the domestic currency (i.e. in euro). In other words and as an example: Italian banks are first supposed to take a loan at 1% from the central bank and then use it for buying Italian government bonds at 6% (or whatever prevailing rate which is higher than 1%). Alternatively, if the government bonds should not be attractive, perhaps banks would lend via the EFSF / ESM? This would be even safer opportunity to use central banks’ money for earning profits.

Thirdly, unlimited liquidity guarantees for eurozone banks are supposed to do what the EFSF has failed so far: improve market sentiment. Indeed, some are already applauding to the ECB (read for example the FT’s article “Is the ECB doing enough to solve crisis?”). Yes, everyone recognises that although the LRTOs may have succeeded in breaking the negative spiral of rising risk aversion, poor asset performance and forced selling, it’s still a short-term measure (a comparison with the “Artificial life and Dolly the Sheep”) and buying time for... the creation of a single eurozone bond market and perhaps a federalist fiscal structure, with a stronger lender-of-last-resort role for the ECB (the later, I guess, is still not in the immediate agenda).

Fourth, in result of (1), (2) and (3), banks’ profits would improve, and thus also their capital positions. The hope seems to be that market confidence will be regained and the banks’ profits will pick up quickly enough so that the need for direct capital injections and other measures such as further SMP purchases are minimal.

The key question is: how much liquidity can the Eurosystem (ECB and central banks of the eurozone member states) actually provide? Currently (as of 20 January 2012) its leverage is ca. 33.2 times (simple calculation: total liabilities divided by the capital and reserves), and capital and reserves amount to approximately EUR 81.6bn. At the same time, the ECB holds Greek debt with a face value of about EUR 40bn, and the eurozone governments are discussing whether the currency bloc's central banking system should accept losses on its holdings of Greek debt. (Source: WSJ). If central banks would have to take their part of the losses, there would still be some room for providing liquidity to banks (let’s say, in the amount of EUR 300bn, maybe EUR 400bn). Taking into account the possible multiplier effects, this seems to be ok. But time is running and we don’t know how everything will play out with the other countries...

... I still keep wondering what a nonsense our financial and monetary system actually can be, and how much it depends on subjective factors such as market perceptions. One cannot neglect that what is being done, is clearly “printing” banks out of the debts (that’s how the new liquidity requirements and stricter capital rules will be met). In this light, “sitting on a pile of money” does not look like a good idea.

No comments:

Post a Comment