(Reuters) – The European Central Bank is hoping a new round of long-term loans will be used by banks to drive down borrowing costs – a substitute for an asset-purchase scheme of its own which would avert a potentially damaging internal split.
The ECB unveiled the loans plan last month as part of a package of measures to breathe life into a sluggish euro zone economy, where inflation is running far below the central bank’s target and there is a dearth of credit to smaller firms.
Presented as a means to foster bank lending to businesses, the scheme is in fact a hybrid program that also offers banks access to cheap funding for four years with which they can buy financial assets.
Policymakers hope that in the round it will create a “credit multiplier” effect, tantamount to enabling the private sector to embark on quantitative easing (QE) – creating money to buy assets to keep borrowing costs low and boost spending – on the ECB’s behalf.
“It’s loans but not only loans,” ECB Executive Board member Peter Praet said of the funding program.
“It’s also the liquidity injection, the funding substitution,” he told Reuters in Paris on Wednesday.
The idea is that one or more of three things will happen:
Banks will use the money to lend to households and businesses, thereby directly helping to revive the economy; they take the money and buy assets themselves; they use the funds to substitute for issuing their own debt.
The latter two could lower the funding costs for all banks, even those who don’t take the ECB’s money, and spill over into looser conditions in the broader corporate credit market, hopefully making money cheaper and easier to access.
In a speech in Paris on Wednesday, Praet said the loans plan, or TLTRO, “has the potential to halt the vicious circle of constrained lending, weak macroeconomic conditions and elevated loan delinquencies, and re-ignite a positive ‘credit multiplier’ process”.
Under the plan, banks can borrow up to 400 billion euros ($545 billion) in September and December at a slight premium to the ECB’s regular funding operations. They have subsequent opportunities running through to mid-2016 to take additional loans.
Banks that have shown positive net lending between April of this year and the new funding operation can borrow up to three times their net new lending in that window and keep the money until 2018, so long as they continue to increase lending.
The terms of the plan do not stipulate, however, that banks must devote all the ECB loans to new lending, allowing the possibility of using some of the money for their own funding purposes or to buy assets.
“They are offering banks very cheap funding and asking the banks to expand their balance sheets, and in the process they will create money and they will buy assets,” said RBS economist Richard Barwell.
“That will look an awful lot like what the ECB might have done themselves,” he said. “But it won’t be the ECB buying the assets, it will be the private sector buying the assets. So to me it looks a lot like arms-length QE.”
Quantitative easing involves a central bank buying financial assets from banks and other private institutions with newly-created money, thereby increasing the amount of cash sloshing around an economy which should make it cheaper to borrow and easier to spend.
The money from the TLTROs (targeted longer-term refinancing operations) will eventually be repaid but it will expand the euro zone’s money supply for four years.
BARRIERS TO QE
At the ECB, hopes are being pinned on the long-term loan operation to deliver the goods.
“We’ve taken decisive action in June, if this is not enough we will do more but we have no reason to believe this will not be enough,” ECB board member Benoit Coeure said on Wednesday.
But what if the plan doesn’t make a significant difference?
Many banks are in risk-off mode as they shape up for ECB health checks before the central bank takes over supervision of Europe’s bigger lenders from November. And there is no guarantee they will loosen up on lending thereafter.
There is also the question as to whether there is corporate and consumer demand for a lot of new borrowing.
“I think the big headwind on the credit multiplier is the banks themselves,” said Sassan Ghahramani, CEO of New York-based SGH Macro Advisors, which advises hedge funds.
“It’s a terrible environment for them,” he said with reference to the ECB health check and pressure for capital restructuring. “Undoubtedly it (the TLTRO) is going to help rather than harm. The question is the multiplier issue – there is a bottleneck with the banks.”
The ECB also wants the plan to work as the barriers to the central bank embarking on an asset-purchase program itself are high.
Sabine Lautenschlaeger, a former Bundesbank vice president who now sits on the ECB’s Executive Board, the nucleus of the broader policymaking Governing Council, said on Monday a broad ECB asset-buying plan should only be unleashed in an emergency such as the imminent threat of deflation.
“Such risks are, however, neither perceptible nor do we expect them,” she said.
Hours after ECB President Mario Draghi’s news conference last Thursday where he said the ECB could yet do more to loosen policy and that there was unanimous agreement to do so if necessary, Bundesbank chief Jens Weidmann responded that interest rates should not be left too low for too long.
SMALL WINDOW OF OPPORTUNITY
Even those less opposed see no prospect of unleashing QE soon. The consensus among ECB policymakers is that they must first allow the package of measures announced in June – which included cuts to all the main interest rates – to take effect and that this will take them into next year.
Even if the Council were to favor QE in 2015, the global policy environment might make embarking on such a policy tricky as the U.S. Federal Reserve is expected to start raising interest rates around the third quarter.
A tightening of Fed policy would lead to a repricing of risk and could prove a difficult environment for the ECB to head firmly in the opposite direction, according to people familiar with the ECB’s thinking.
That leaves a potentially small window of opportunity and means the TLTRO really needs to work.
“We will implement what we decided in June including the targeted long term refinancing operation and we are very confident that this will help,” Coeure said.
One consequence could be to generate a so-called ‘portfolio rebalancing effect’ whereby banks use TLTRO funds to partially substitute for issuing their own bonds.
Praet said in Paris that via such a substitution effect “the TLTROs can create a scarcity of investible assets, which will result in lower yields and easier market funding conditions even for banks that have not taken part in the operations”.
If banks take the ECB money and issue fewer of their own bonds as a result, so the logic goes, then the diminished supply will push up prices and lower yields on bank bonds.
“It may also create spillover effects to other segments of the corporate credit market, as investors in bank bonds will be induced – by a scarcity of supply – to diversify away from that market and re-invest in other market segments,” Praet said.
A downside of the ECB’s plan is that it cannot fully control what banks choose to do with the new money.
Aside from fulfilling their obligation to keep their lending on an upward trajectory, banks can choose to fund themselves or buy assets with the cheap ECB money as they like.
But that may be a price worth paying to avoid a bloody battle over printing money which, for some in the ECB, remains the ultimate taboo.
“There is a compromise here,” said Barwell at RBS.
“They (the ECB) have given up essential control over what assets are bought and what the final impact will be but they’ve avoided having to call the shots themselves – they’ve avoided that endless debate about what to buy and whether QE would allow politicians to drag their feet on reforms.”