LTRO: Third time lucky?
An overwhelming majority of investors believe that another LTRO is inevitable. The previous two interventions disrupted normal market operations. The ECB must tread carefully with its third.
Another longer term refinancing operation from the European Central Bank looks increasingly on the cards. Fitch said last week that more than four out of five European investors expect a third LTRO. Many bankers reckon it is impossible to avoid.
If the ECB decides to pull the trigger on another handout, it will have to very cautious if it is not to cause problems elsewhere. When it comes to such interventions, unintended consequences are rife.
Take interbank repo, for example. Icma's European Repo Council last week warned that volumes in this market had dropped nearly 10% in the last six months. It points the finger squarely at the ECB's LTROs. Institutions were given €1tr of three year money at 1% — something they would never get on the interbank market.
The calming effect the LTROs had on markets cannot be denied. But there were also concerns that the ECB stepped beyond its remit to provide liquidity to banks with market-access problems and was instead keeping failing institutions solvent.
With periphery economies still reeling, the bank may well consider a third slug of money to be the best way to stave off chaos. But it will have to grapple with plenty of thorny problems.
Lengthening the tenor from three to five years, as some market chatter has suggested might happen, would be a mistake. It would send exactly the wrong signal — that banks need more than three years to deleverage, which would hardly alleviate fears of zombie banks being kept alive artificially.
Timing is also key. The two previous LTROs have taken their toll on repo and there could be more consequences down the line. The ECB should resist the urge to open the liquidity floodgates at the first sign of trouble, putting more pressure on markets.
When the existing LTROs come to an end — in late 2014 and early 2015 — some of the banks involved may still not be strong enough to come off the funding. Short-term markets may also still be too weak for normal business to resume.
In such circumstances, the ECB would be justified in launching a third operation as part of a weaning-off process — letting those that can come off its supply do so naturally, by rejoining the capital markets, while those still struggling to pay off the previous operations would have another three years to do so.
In theory, that ought to point to a much more expensive deal, so as to incentivise a market return for those that can and avoid the worst distortions that a free lunch can create.
Of the rest, those that can show genuine progress — but might still need a helping hand — should be given assistance. But those that cannot ought not to be allowed a stay of execution. Three years is long enough. Banks that have not made progress by then are too weak to save.