The ECB Long-Term Repo Operation is about price not quantity

By Warren Mosler

When it comes to CB liquidity operations, as previously discussed, it’s about price- interest rates- and not quantities of funds. In other words, the LTRO is an ECB tool that assists in setting the term structure of euro interest rates. It helps the ECB set the term cost of funds for its banking system, with that cost being passed through to the economy on a risk adjusted basis, with the banking system continuing to price risk.

So what does locking in their funds via LTRO do for most banks? Not much. Helps keep interest rate risk off the table, but they’ve always had other ways of doing that. It takes away some liquidity risk, but not much, as the banks haven’t been euro liquidity constrained. And banks still have the same constraints due to capital and associated risks.

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To it’s credit, the ECB has been pretty good on the liquidity front all along. I’d give it an A grade for liquidity vs the Fed where I’d give a D grade for liquidity. Back in 2008 the ECB was quick to provide unlimited euro liquidity to its member banks, while the Fed dragged its feet for months before expanding its programs sufficiently to ensure its member banks dollar liquidity. And the FDIC did the unthinkable, closing WAMU for liquidity rather than for capital and asset reasons.

But while liquidity is a necessary condition for banking and the economy under current institutional arrangements, and while aggregate demand would further retreat if the CB failed to support bank liquidity, liquidity provision per se doesn’t add to aggregate demand.

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What’s needed to restore output and employment is an increase in net spending, either public or private. And that choice is more political than economic.

Public sector spending can be increased by simply budgeting and spending. Private sector spending can be supported by cutting taxes to enhance income and/or somehow providing for the expansion of private sector debt.

Unfortunately current euro zone institutional structure is working against both of these channels to increased aggregate demand, as previously discussed.

And even in the US, where both channels are, operationally, wide open, it looks like FICA taxes are going to be allowed to rise at year end and work against aggregate demand, when the ‘right’ answer is to suspend it entirely.

UPDATE: The initial rate on the 3 year LTRO was reported to be ‘fixed’ at 1%, but turns out it adjusts with the policy rate and will be an average of the policy rate over the three year term.

So it doesn’t fix rates for the banks, it just ensures funding at the policy rate. Which makes sense, as the bank’s cost of funds is the policy instrument of the ECB.

Also interesting is how in the case of bank defaults the member nations guarantee the bank deposits. But those member nations get their funding from bond sales. And with the weaker ones that means bond sales to the ECB. So in that sense, the ECB is backing bank deposits. Which means when it provides liquidity and takes collateral, should the bank subsequently realize losses, causing the ECB to realize losses on the funds provided to the bank for liquidity, the member nation would then sell bonds to the ECB to get the funds to pay for the loans it got from the ECB.

Again, it all comes down to the ECB writing the check. And it all works from a solvency point of view when the ECB writes the check. And the ECB writing the check introduces a serious moral hazard issue. Hence the (over) emphasis on austerity.

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1 Comment
  1. Anonymous says

    This is about refinancing insolvent banks. The banks will not be buying sovereign debt. They will use it to bolster their balance sheets. There are no requirements for them to do anything else. In fact I can see the really strong banks taking as much of these loans as possible because the cost of funding is so low that they can easily make enough to cover the costs. They will then be much more solvent come the next banking crisis which I believe will be shortly as the Latvian banks are already in trouble. 

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