The buck stops with the ECB. Actually, the buck stops with the Fed; only the euro stops with the ECB, but until the English language catches up with European monetary union, that will have to do.
2012 should be the year of the ECB. While European banks are busy hawking their assets to anyone that has money left, the ECB’s balance sheet will carry on swelling. It stands at €2.73tr at last count (balanced on a delicate sliver of €81bn in capital, or 3%) and nobody would pretend its work is done.
But this balance sheet swelling comes at a cost. Collateral pledged to the ECB stops there. There is no rehypothecation; no attempt to squeeze a little extra from the balance sheet.
A private bank will always try to work its collateral hard, pledging it away for another slice of funding and creating a web of financial interconnection. Banks that need to cover shorts get easy access to collateral; banks that need funding get a ready source.
Moving collateral faster means doing more with less. If chains of rehypothecation get longer, that means banks get more funding against less security.
In normal times, this works fine — the central bank stands behind the chain, and if something goes wrong, banks can pledge collateral there instead, for a price.
These aren’t normal times though. Instead of standing behind the repo market, the ECB is accounting for an increasingly large share of the total, substituting for dysfunctional parts of the private market.
But this means the ECB’s role at the end of the chain becomes more of a problem. Instead of lending credibility to the private market, it is stopping it dead in its tracks. Collateral pledged to the ECB goes nowhere — it disappears from the banking system for the duration of the repo, now available for up to three years. Assets purchased outright are similarly wasted — the ECB’s covered bond purchases sit similarly mute and useless, while the private banking system cries out for more triple-A paper.
Of course, large portions of the ECB’s balance sheet are well out of the way, and nobody wants to see these dark corners of the market revisited in 2012. It is sitting, uncomfortably, on large stocks of peripheral ABS and covered bonds. Pushing these back out to the market would depress prices further, meaning the banks that are dependent on raising funds against these assets have to post yet more collateral.
But parts of the ECB’s stocks of covered bonds and corporate bonds could be usefully lent back out to the market.
The central bank has the useful ability to be neutral across an asset class, and across counterparties — it can sit in the middle of a repo chain, and strengthen the private market, rather than removing it.
Having the ECB as a counterparty instead of a small peripheral bank means trades will get done that otherwise would not.
Northern European liquidity providers — the banks with €446bn on deposit at the ECB — will happily take collateral for their deposits, and by doing this, the ECB can funnel collateral back into the private banking system, raising liquidity in the interbank and bond markets.
Rehypothecation is nothing more than a confidence trick — to reuse collateral over again means confidence that your counterparties deliver on time, or that you can source assets in the market. But confidence is what interbank markets need, and the ECB can provide it.