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Draghi: B minus, could try harder

The measures Draghi announced last Thursday aren’t bad, but he could have done much more. A few simple changes could mean a lot more liquidity for the European banking system. The only loser would be the ECB’s pride.

“Lend freely against good collateral, at a penal rate.” Walter Bagehot’s prescription for central bank action in a crisis was as good in 1873 as it is today. But the ECB seems to be straying ever further from this ideal.

ABS is the largest category of repo collateral at the ECB, and the type that attracts the most vicious haircut. But why?

The ECB says its collateral haircuts are driven by market liquidity, but this is disingenuous. How many Greek sovereign bonds could it sell on an open market? What market liquidity would be available for its holding of peripheral covered bonds?

This is as it should be. The system wouldn’t need a lender of last resort if the markets were providing enough liquidity. A central bank should take the view that the collateral it accepts is good enough to provide liquidity against, even if the market does not think so.

The question the ECB should pose is about whether the collateral it accepts will suffer a credit loss, not whether it can sell its collateral pool in the market — we all know it can’t.

On Thursday, the ECB announced it would allow the second rating on ABS to be as low as A- — a reversion to the situation that existed before March this year. This will affect only new issues, and only Ireland and Portugal, where sovereign rating caps from the agencies stop new issues achieving the top rating.

Analysts at RBS explain that “the extended scope of ABS eligibility should have minimal, if any, effect in expanding the repo-able base of legacy or secondary ABS.”

But all ABS — whether structured with lower ratings or not — will still attract a 16% haircut.

The implications of this number are worth examining. Senior tranches (the only eligible tranches for the ECB) in European consumer ABS have suffered losses of 0.7% since 2007. So to get to losses of 16%, loss severity would have to be 23 times larger than in the largest recession in recent history.

If the ECB cut the haircut to the same level as that for covered bonds (which ranges from 3.5%-5.5%), it could immediately raise another €120bn of liquidity for European banks. Even to match ABS to senior unsecured debt — which attracts a 6.5% haircut — would mean €78bn of extra liquidity overnight, based on the existing stock of ABS collateral at the ECB.

The irony is that the ECB may already be planning such a move, but waiting for political cover to do so.

That cover could come from the Prime Collateralised Securities (PCS) initiative, a label designed to distinguish the best-quality securitisations — setting apart well-performing European ABS from, say, US subprime. Structured finance market participants involved in the PCS are confident that when the initiative goes live in the New Year, the ECB will relent, cutting haircuts for PCS-backed deals.

This should open the way to relax the more punitive anti-securitisation provisions. PCS-labelled ABS could even be included in bank liquidity buffers under CRD IV.

But why is the ECB, an independent central bank, looking for political cover?

If it cuts haircuts after the PCS comes in, that will be welcome. But why wait? It could change the policy tomorrow. European banks need liquidity now, and the ECB has the tools to give it to them.

Someone should tell them there’s a crisis on.

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