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A tale of two collateral markets
The BIS quarterly review, which was published last week, provided some interesting thoughts on current liquidity and funding conditions (both secured and unsecured) — and how central bank transmission mechanisms have been affected as a result.
An important consideration, yet to be fully appreciated, is the divergence between private and public collateral and funding markets.
Simply put, back in the pre-crisis days the two markets worked in tandem. Participants engaging with the ECB did not differentiate on the type of collateral they delivered to the ECB versus the type of collateral they held back for use in private funding markets.
The crisis changed all of that.
Suddenly the cheapest collateral to deliver became the collateral of choice for ECB use. The most expensive or ‘quality’ collateral was held back for use in private markets.
A tale of two collateral markets
This is how central bank transmission mechanisms began to be compromised.
The private funding markets, dictated by interbank participants, could from now on only be influenced by large quality collateral holdings — which the central banks increasingly lacked. The public funding market, dictated by central banks, became the domain of trash collateral — which no one really cared about.
The central bank monopoly on the ultimate cost of money thus became based around access to trashy collateral, not quality collateral — which remained the preferred funding option for private markets.
Unfortunately, it’s private liquidity which ultimately determines the scale and depth of the eurozone crisis — and it’s in this market where ECB influence is waning:
From the BIS (our emphasis):
Official and private liquidity interact in various ways. One way to think about this interaction is the traditional money multiplier concept: by determining the risk-free short-term interest rate and the amount of funds available to settle payments through the central bank, official liquidity is the basis for private liquidity creation. In times of crisis, however, private liquidity tends to evaporate and global liquidity collapses into its official component – or, to use the money multiplier analogy, the multiplier falls to zero.
In those circumstances, global liquidity will crucially depend on individual banks’ access to official sector funding. This is particularly relevant when banks’ funding needs are in a foreign currency, constraining the ability of the domestic central bank to address liquidity shortages, as observed in late 2008.
There are important implications here. Private market liquidity preferences begin not only to dictate the cost of funding outside of the ECB, but also bring about important consequences in terms of monetary flows:
But the interactions between private and public liquidity are arguably more complex than this conventional view suggests. For instance, private capital flows may lead to foreign exchange reserve accumulation (increasing official liquidity), and the reinvestment of these reserves in the liquid assets of other countries may help to further ease financial conditions (increasing private liquidity). There are signs, for example, that the channelling of large reserve holdings into government securities can contribute to global liquidity conditions through its effect on yield levels (Graph 1, right-hand panel)
In other words they can begin to influence things like currency basis swap rates and via that foreign currency reserves, as flows head into markets deemed as offering ‘quality’ securities.
The BIS, having now realised that it’s not enough to just influence one part of the collateral funding market makes the following point:
First, policies need to take into account the full liquidity cycle – liquidity surges and their associated contributions to systemic risk as well as liquidity shortages or disruptions in the provision of private liquidity. Second, policy frameworks need to be sufficiently robust to uncertainty about the exact sources and impact of global liquidity surges and sufficiently flexible to address sudden shortages in liquidity conditions at the global level.
Another way of looking at it is to understand that the decision to replace private funding through central bank liquidity has only encouraged trashy collateral dumping in central banks — and heightened the divide between private markets and public markets.
The two are running increasingly off course. Unless central banks act collectively to re-establish control of quality collateral markets, no matter how much liquidity they provide against trashy collateral — it won’t make much of a difference.
Private markets must be convinced to lend unsecured or invest money in more than just the last few remaining AAA bond markets.
But as they say, you can lead a horse to liquidity but you can’t make it drink. Which is a shame, because that’s the main problem the ECB and other central banks are now facing: they are leading banks to liquidity but they can’t make them lend in private markets.
Related links:
Le plan, negatifs taux d’intérêt, redux – FT Alphaville
One Eurobond to rule them all – FT Alphaville
The German bond market is all about ‘buy and hold’ - FT Alphaville
When a government bond becomes a Giffen good – FT Alphaville
The carry trade and the goldilocks LTRO
The FT has already reported on how hesitant banks are about buying ever more sovereign debt. In fact they outright dumped €65bn of bonds in just nine months. Hopes that banks would hold the hand of the sovereigns that back them continue to dim, as the Sarko carry-trade looks increasingly less likely in advance of this Wednesday’s offer of cheap 3-year ECB financing.
The presumption that banks are going to use the 3-year Long Term Refinancing Operation (LTRO) to buy sovereign bonds comes not just from the dreams of certain politicians, but also from the observation that yields at the short end of peripheral curves have come in dramatically.
Spanish bonds provide an example (chart courtesy of SocGen):
From the above, European financials have deteriorated over the last week while the yields on Spain’s government bonds have been coming in. Is this the result of banks buying up the high yielding bonds that they will soon be able to fund exceptionally cheaply?
Not so much, say the analysts at SocGen in their Rates Strategy daily this Monday. There are many factors at play, and true, one of them may be the anticipation of banks putting on carry trades, but the expectations may not transform into reality.
For one thing, banks are going to have to find a way to fund their existing asset holdings — to the extent that they don’t deleverage themselves into nothingness, that is — and a good portion of the current funding for them will roll off in 2012. SocGen points out that for eurozone banks in 2012, €250bn of senior unsecured bank bonds will mature, along with €83bn of government guaranteed debt, plus €19bn of subordinated debt.
Seeing as the unsecured market is somewhere between frozen and inaccessibly expensive, the most relevant candidate for the replacement of that debt is reckoned to be around €185bn of covered bond issuance, a figure which the analysts acknowledge may well be a bit on the high side (though at least it will be supported by another ECB programme to specifically prop up that market).
The rest of the funding needs to come from somewhere. And, well, the ECB is offering…
True, the ECB ties up collateral as equally as covered bonds do, but there is an extra attraction to the LTRO: the banks that take the 3-year funding will in fact have the option to repay any part of it after just a year, hence freeing up the collateral held against the borrowing at the ECB. Nice option… that isn’t too consistent with the whole “carry trade” concept where the maturity of the asset is matched to the term of the funding for it, the rates team at SocGen points out.
Oh, and the collateral posted to the ECB can be relatively low quality. Not like the stuff required for private markets, or for covered bond pools.
One thing that actually joins the LTRO on the supply-side for liquidity, according to SocGen, is the lower reserve requirements that will kick in for the maintenance period starting on January 18th. Falling from two per cent to one per cent will free up some €100bn that was on deposit with the ECB — something that will happen in advance of the second 3-year LTRO at the end of February. However, the SocGen analysts expect that this move will more likely lead to a decrease in weekly main-refinancing operations (MROs), than a decrease in LTRO demand. One to be aware of, anyhow.
But back to how unlikely carry trades are:
There are several obstacles to carry operations, namely the stricter capital requirements, the pressure on banks to deleverage; and the stigma attached to such trades if ever revealed.
Put even more simply, do you think a bank that shows an increase in sovereign bond holdings in their quarterly reports will find it easier or harder to fund itself in private markets?
And what if there is yet another EBA stress test that whacks sovereign holdings and then demands additional capital for potential losses? How clever will a sovereign carry-trading bank look then?
In addition to that, if the bonds were to reverse course and start tanking again, the banks would have to post additional margin on them.
All of that said, could the banks make a dent if they wanted to? Out of some sense of patriotism perhaps? Emphasis ours:
Euro area banks have some 6% of total assets in government bonds (with ratios slightly higher at 7% to 9% in Spain and Italy as per the most recent EBA data). If half of all Spanish and Italian banks (it is unlikely to be the larger names) were to raise the ratio by 1% next year, that would lead them to buy some €8bn-€10bn in each country. Most likely the impact would be far less, and graduated over time. Buying though on such a scale is modest as a percentage of total issuance (some 9% in Spain, 4% in Italy).
That’s a “no” with words. Here’s the same with a graph, courtesy of Deutsche Bank with a couple of FT Alphaville modifications:
In the end, SocGen predicts a demand for €200bn on Wednesday.
RBC is in a similar ballpark, but warns that there’s a risk that the uptake could be lower than expected. There are currently already €350bn in excess reserves parked at the ECB which is much higher than they were prior to previous LTROs:
Furthermore, banks can fund the €432bn of tenders that mature this week with the weekly MRO and 3-month LTRO, so they don’t necessarily need to go to the 3-year tender just to keep things constant.
In addition to this, the RBC team notes that the exact details on the expanded range of eligible collateral hasn’t actually been decided yet, so it may not be clear to banks whether they have newly-eligible assets lying around that they may otherwise be willing to post.
In conclusion (emphasis ours):
A not too small outcome should suggest that banks use the new facility and get longer dated funding on board. This should sooth some anxiety about their funding risks going into 2012. A not too large outcome should also suggest that no unreasonable risks have been taken.
It’s the goldilocks of refinancing operations.
Related links:
Why ECB lending won’t solve the euro crisis - Felix Salmon, Reuters
How big could the Sarko trade go? – FT Alphaville
Stark and Draghi on the haters - FT Alphaville
Doubts over ECB move to boost bond sales – FT
Banks resist European pressure to buy government debt – IFR
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