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Be straight with us, Andrea — and don’t penalise LTRO users

It would be madness for the European Banking Authority not to consider the impact of the European Central Bank’s long term refinancing operation (LTRO) in next year’s stress tests for the bloc’s lenders. But should banks really be penalised for making use of a funding tool that was designed to help them?

After rumours surfaced on Monday night that the EBA was considering marking down banks that were reliant on LTRO funding in next year’s stress tests, by comparing the cost of funding through the scheme with the cost of funding in the wholesale market, EBA chairperson Andrea Enria issued a statement saying that his organisation had “not discussed the treatment of the LTRO is any future stress test”.

He added that the EBA “does not see its role in making assumptions about possible monetary policy actions” and that it was working closely with the ECB to develop an appropriate methodology.

To many, that sounded like a denial of the penalisation rumour and then an admission that it could still happen, mostly because it would be absurd to think that the EBA had not discussed the treatment of the LTRO in the stress tests. Of course it has — it is a fundamental feature of European banks’ balance sheets.

For once, it would be nice to see a European institution be more straightforward about these things. It matters because rumours like this don’t come from nowhere, and now the market is contemplating a set of stress tests which will see vulnerable banks in Europe’s peripheral states punished for using a liquidity lifeline that was designed specifically to help them — even if Enria tries to convince it otherwise.

Mario Draghi has made it clear that the ECB is ready to step in to help Europe’s banks with another LTRO, if it is deemed necessary, possibly in a longer maturity than the original three year operation. Of course the EBA is going to want to know whether this funding will be offered before it embarks upon a costly and time-consuming set of stress tests.

But marking banks down for using the scheme is not the way to go. Yes, using the LTRO means you have a refinancing risk when the scheme ends. Yes, European banks do need to be weaned off central bank support. But the LTRO isn’t some fickle form of money market financing, vulnerable to market shocks — it is Mario Draghi’s flagship crisis-fighting mechanism.  

Everyone knows its terms, and they know they must prepare for when the scheme ends and the funding must be paid back. The LTRO has become a fundamental part of the base case for European banks, and penalising banks that use it — some because it is the only funding they can access, others because by executing the sovereign carry trade they can build up capital — simply weakens the perception of already vulnerable lenders.

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