February 5, 2017    3 minute read

The ECB’s Collateral Damage

Piling It Up    February 5, 2017    3 minute read

The ECB’s Collateral Damage

Trying to achieve inflation in an area which views lower oil prices as deflationary shows just how entrenched expectations are. If the Europeans were large-scale exporters of oil, they should be worried about a $55 price tag, but they are large scale importers.

It has been well documented that the ECB has ventured significantly off its original mandate which, by the way, is a necessary but not sufficient condition. Or is it? What is sufficient is government action, not government bickering.

A Changing Environment

The current condition is one in which these large-scale asset purchase programs are entering the counter-productive zone. So much so that like the Japanese, the ECB is heading towards the limit of QE. In other words, it is not just the distortion effect of sovereign borrowing costs and its impact on equity markets, but more simply, they are simply running out of assets in the market to buy (at its current mandate; it could be widened to include higher-yielding debt – this could be classed as risky but so was buying mortgages in 2008 by the Federal Reserve. What is riskier is another lost decade).

In Japan, the central bank owns around 80% of the government bond market. In Europe, it is heading for something similar. But fundamentally, what would be the impact of hitting this ceiling?

The problem in the European banking system is that a significant amount of bad loans still sit on the balance sheet as “assets” when in actual fact, the chance of collection is non-existent. So, in essence, they are a liability. Not to mention that the commercial banks and the government have been bound together from the various longer term refinancing operations (funding for the commercial from the ECB that needed government bonds as collateral, which in turn compressed spreads across the periphery).

The Next Batch of Collateral

Ironically, all of these swipes on a keyboard could cause a euro area banking crisis. This liquidity solution is great until the main buyer, the ECB, cannot buy anymore. Commercial banks often use high-quality liquid assets as collateral when they borrow in the European interbank market. So what happens when the ECB has acquired all of the banks’ collateral? Two things.

First, in order to borrow from peers, the banks would be scrapping the barrel and putting forward less good collateral, which results in a haircut on the initial amount. For instance, if Banco Santander wanted to borrow €50m for a week but put forward commercial paper instead of higher quality sovereign debt, they would only be able to borrow 60%-70% of that €50m, maybe not even.

That is not ideal because if the bank asked for €50m, it would for a distinct purpose, i.e., funding a short-term liability. If the bank could not pay its short-term debts, the system would grind to a halt very fast. No one needs to be reminded of 2007-2009.

The second issue relates to interest. Euribor (European interbank offered rate) is the price of this short-term lending. Again, if the assets used as collateral are of significantly less quality, the lender is taking on more risk, resulting in higher interest payments to compensate. Euribor has spiked of late as the ECB’s predicament becomes closer and closer.

Conclusion

So ironically, the transmission of QE is indeed helping to compress spreads because the ECB is buying them. But that is the problem: the ECB is buying them, which is causing higher interest rates for short-term bank funding and with higher haircuts. When the experts talk about central banks becoming counter-productive, it would be difficult to find a more damaging issue.

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