On Liquidity: Watch What the ECB Does, Not What It Says
Many observers seem to be looking at the 523 banks that took 489.1 bln euros from the ECB’s 3-year repo operation and recognize it to be on the upper end of expectations. Yet the situation is more complicated and the injection of new liquidity is not nearly as much.
Note that the ECB provided funds in three different facilities. 169 bln was taken in yesterday’s 7-day operation and another almost 30 bln taken at the 3-month refi today. Combined with the 3-year operation, this is a provision of 688 bln euros.
This is where most comments have stopped, yet it is only one step. The other key step missing is that amount rolling off. Between the 7-day and 3-month expiration, there was a 432 bln maturing. On top of that almost 46 bln of the old 1-year facility was rolled into the new 3-year facility. Together this is 478 bln euros that need to be replaced.
The difference between the two sums–the provision of funds minus the maturing amount (688-478 bln) means the real new next injection of liquidity is about 210 bln euro. On a duration-weighted basis, it is even greater, though this is more difficult to calculate and a number of assumptions have to be made.
There is another 3-year auction at the end of February. Before it, the lower reserve requirements will be implemented and this will free up 100 bln euros that are current on deposit at the ECB. In addition, the ECB is drawing more on the dollar swap lines and provided another $33 bln for two-weeks (covers the roll), replacing $5.2 bln of a 7-day facility that was expiring.
This is on top of the 3-month $50.7 bln provided earlier this month. The ECB’s liquidity provisions, even if not as large as may seem on a cursory look, are quite substantial and should help ease the liquidity squeeze that had been identified as an urgent problem.
The key question remains what the banks will do with the newly acquired funds. We suspect that to the extent banks buy sovereign bonds, they will purchase their own sovereign’s bonds rather than their neighbor’s. More details of the nuances of the auction will likely be forthcoming over the next several days, but it is notable that several Italian banks, include the two largest Italian banks reportedly created bonds, which were guaranteed by the government, for apparently the sole purpose of creating collateral to borrow from the ECB today.
This has in turn fueled speculation that the banks have run out of collateral. In the scenario we have depicted, which we think is the most likely next year, that there is No European bond, No ECB sovereign back stop and No euro zone break up, it is vital the ECB provides ample liquidity (and our point is more is coming). The liquidity dimension of the debt crisis can be addressed, and this reduces the risk of the extreme tail events, arguably.
Many observers have been focused on the sovereign debt that needs to be rolled next year (~800 bln+ euros), but have often not given due to the bank debt that is also maturing and needs to roll. In Q1 alone euro zone banks have an estimated 230 bln of maturing. We expect the bulk of the ECB’s liquidity provision will not be used to buy sovereign bonds, but to address the banks’ own needs.
Among the needs is to secure funding in case the markets are not very hospitable. It would not be surprising banks kept liquid. This could mean that the overnight deposits at the ECB increase from the already elevated levels. In the near-term it may also suggest the ECB will not have much difficulty sterilizing its bond purchases.
Lastly, investors should pay more attention to what the ECB does than what it says. It says it will not backstop sovereigns, yet since it has renewed its bond purchases in August, its bond purchases have almost matched the new bond issuance of Italy and Spain. The ECB’s rhetoric seems somewhat harsher than its actions. To be sure the liquidity provisions are not and cannot be the "bazooka" that so many want. It does not cure what ails Europe, but it treats it and will have to continue to do so in the months ahead.