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Turning off the taps — is there life after the central banks?

Unprecedented support from central banks, both in terms of monetary policy and cheap liquidity, has characterised the past few years of the financial crisis. Markets have reacted badly to signs that central banks are thinking about an exit plan — but is it time to let banks stand on their own two feet again? Will Caiger-Smith investigates.

A year after European Central Bank president Mario Draghi pledged to do “whatever it takes” to save the euro, are banks better or worse off? It depends who you ask, and indeed, which banks you’re talking about.

What is clear, though, is that the bank funding markets are anything but normal. Central bank support has been the defining feature of the capital markets for at least the past three years, if not longer, and it has drastically altered the way banks operate.

Quantitative easing in the US, the UK and Japan has pumped trillions of dollars into the system, and the ECB’s three year longer term refinancing operation (LTRO) has been hailed by many as the “big bazooka” that saved Europe’s lenders from illiquidity Armageddon at the end of 2011. Banks took €1tr of cheap three year funding in the two operations, which mature in January and March of 2014.

While the UK’s Funding for Lending scheme was not as pivotal a measure as the LTRO, it underlined the Bank of England’s commitment to providing emergency liquidity.

These unprecedented measures saved the market from meltdown, and since Draghi’s speech, funding costs have come down sharply — the iTraxx senior financials index has tightened 161bp to around 134bp, while the subordinated index is around 272bp tighter at 206bp.

A blessing and a curse

But central bank support has also twisted the market almost beyond recognition, says Vincent Hoarau, FIG syndicate at Crédit Agricole.

“The two LTROs eased the liquidity crisis by offering alternative tools to wholesale capital markets funding, preventing many banks in critical liquidity situations from going bust and restoring a fragile confidence in the eurozone banking system,” he says. “They also increased excess cash in the market and triggered a strong imbalance in terms of the supply, demand and redemption dynamic across asset classes.

“Market participants stopped pricing fundamentals and started pricing liquidity, bringing credit spreads to all-time lows, particularly in covered bonds. Spread levels are justified not by the economic situation but by the level of liquidity and excess cash in the markets. Valuations started to get irrational, so it’s not a surprise now to see talk of tapering inspire panic. You only learn who’s been swimming naked when the tide goes out.”

Of course, being caught swimming naked can be embarrassing, so it’s no surprise that many investors reacted angrily when Ben Bernanke, chairman of the US Federal Reserve, first uttered the word “taper” — a reference to a possible reduction in quantitative easing — in May this year. 

The subsequent sell-off prompted a robust public defence by the Fed, one of the most memorable moments of which was Dallas Fed president Richard Fisher calling investors “feral hogs” for trying to call the Fed’s bluff by selling off. 

“The reaction to a possible taper of QE by the Fed suggests that it is still an artificial market and the involvement of central banks is still important,” says Simon Adamson, chief executive and senior financials analyst at CreditSights.

Important might be understating it. At some point, artifice became reality — one could argue either that the market became divorced from fundamentals, or that central bank support itself became a fundamental of the market. Without that backstop, investors would feel very differently about putting their vast cash reserves to work at Europe’s banks, Adamson argues.

“There are probably two effects of measures like the FLS and the LTROs,” he says. “There is the fact it gives banks cheap funding in itself, but there is also the fact that it gives the market confidence that if necessary, banks can access unlimited and cheap funding from central banks. It is hard to quantify that, but it must have some effect, although definitely more so with the LTRO than the FLS.” 

Psychological impact

If the LTRO helped banks get funding through the door — whether they were struggling peripheral European lenders, or core European national champions using it to buy high yielding sovereign debt from those peripheral countries — it seems the impact of Draghi’s “whatever it takes” moment has been mainly psychological.

“Banks don’t need another LTRO to access funding,” says Adamson. “Psychologically the most important thing is knowing that they can access the ECB anyway. The idea is that over this period, banks and supervisors ensure that the balance sheet is restructured and banks become less dependent on that funding anyway. Some banks may still be dependent on central bank funding but I would be surprised if those concerns are addressed through another LTRO.”

There is another reason another LTRO might not be necessary, however, and banking analysts are keen to point it out when anyone suggests that banks are too dependent on central bank support.

Banks have been paying back the LTRO, often in large chunks, and faster than the ECB expected. Banks have paid back €334.2bn of the just over €1tr of three year funding they took in the two operations.

But Draghi is cautious about the eurozone’s nascent economic recovery. “These shoots are still very, very green,” he warned in early September.

However, the ECB’s normal liquidity provisions are still there, and the rate at which the three year LTRO has been paid back indicates that some banks don’t know what to do with the money, says Andrew Sheets, head of credit research at Morgan Stanley.

“The way banks are paying down LTRO funds shows they can’t find productive things to do with that money,” he says. “Loan growth is weak, so that makes sense. If there were a third LTRO, I don’t think it would be seen as a broad stress-relieving measure, it would more be a measure to help smaller banks under greater stress.”

Many treasurers agree. One German funding official says that while there were many ancillary uses for the last LTRO — the sovereign carry trade, risk mitigation — if there is another one, people will see it purely as an emergency funding tool.

“The LTRO was a kind of contingency financing for non-core assets, it was a way to externalise funding for our non-core unit,” he says. “We also used it as a risk mitigation tool, to protect against a possible break-up of the euro. We have completely repaid all those LTRO funds now, and are no longer participating. If there were to be a third LTRO, there would be lower participation — people would only use it as a source of funding, and only if they really needed it, rather than for things like risk mitigation.”

Not-so-great expectations

Put a deleveraging banking sector together with a lack of demand for credit and cheap liquidity from the LTRO, and what do you get? A whole lot of investors with a whole lot of cash and very few places to put it. That in itself has led to a technical market situation where supply is far lower than demand — putting further pressure on spreads.

Supply in senior unsecured and covered bonds has been far lower than redemptions this year, even with spreads at historically tight levels. Senior unsecured FIG supply this year stands at €95bn, compared to redemptions of €265bn.

And with plenty of deleveraging still on the horizon — analysts at Royal Bank of Scotland in July said that €3.2tr had been done and predicted there was €2.9tr to come — it is expected to stay low.

That creates challenges for treasurers who have spent years building up relationships with debt investors, based on a presumption of regular supply. How do you keep credit lines open when you don’t need to print public benchmark deals?

The lack of benchmark supply has, however, demonstrated the strength of the private placement market, especially for stronger credits. MTN volumes have remained stable over the past couple of years — Dealogic shows that banks have printed $230.9bn of private placements this year to date, across 17, 623 deals. That is more than the $221.4bn across 15,004 deals printed in the same period last year.

The provision of central bank liquidity and the psychological support offered by Draghi’s pledge to preserve the euro have also contributed to the near death of other, less visible private markets, such as term repo. Bas Iserief, head of long term funding at ING, says the term repo market dried up once the LTRO was announced. 

“There were some banks that were fairly starved of funding and were ready to encumber all sorts of assets for a long time at amazingly expensive levels,” he says. “But by the time investors had got on board, Draghi had saved the world and the market dried up. All these salespeople had all these investors lined up, and we had to tell them ‘sorry, we’re going to do it the other way round now’.”

What you need is a union

As surely as central banks giveth, central banks taketh away. The ECB is to be the single supervisor for the eurozone’s banks — initially only the largest ones, but its reach will extend — from 2014, and some accused it of trying to stamp its authority on the markets in the Cypriot banking crisis.

It used its provision of emergency liquidity as leverage in talks over Cyprus’s bail-out in March, threatening to withdraw Emergency Liquidity Assitance (ELA) from the country’s two biggest banks if no EU and IMF bail-out programme was agreed by a certain deadline.

Sharon Bowles, chair of the European Parliament’s Economic and Monetary Affairs Committee, said she was “astonished” at the very political tone of the central bank’s ultimatum.

At the heart of that country’s crisis was bail-in — the spectre hanging over bank funding markets. By giving regulators the power to inflict losses on bondholders up to senior unsecured level, bail-in fundamentally reshapes the risk profile of senior debt, which had been protected from losses throughout the crisis.

Cyprus was a reminder of that, and a reminder that banking union — comprising the ECB as single supervisor, a single bank resolution mechanism, and potentially a pan-European deposit insurance scheme — is where the European project is headed. Having saved banks in the crisis, the ECB is about to become their master.

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