From former Bank of England MPC member Willem Buiter’s Mavercon blog on Friday:
It is clear that if the ECB were all there is to the Eurosystem, the Euro Area would be in trouble. The ECB has negligible capital (€ 5 billion subscribed, rather less than that paid in; even if we add capital and reserves to 2008 profits, we only get €5.4 bn. With assets of €3839, that gives the ECB 71 times leverage at the end of 2008, a number that would impress even Deutsche Bank. The previous year, the ECB had 48 times leverage. On its own, the ECB looks like an overblown pawn shop.
Luckily for Europe, Buiter explains the ECB’s balance sheet is no indicator of the euro area’s actual financial strength. That’s because about 75 per cent of the bank’s assets consist of Eurosystem claims. Therefore, what is informative is the consolidated balance sheet of the entire Eurosystem itself.
Meanwhile, because a central bank can always print more of its own money, the only factors that can lead it to insolvency are its stock of foreign currency denominated liabilities and/or stock of index-linked liabilities. Luckily again, neither condition seems to apply to the Eurosystem. As he explains:
A shortage of foreign exchange assets or credit lines is not going to be a material problem for the Eurosystem. As of May 8, 2009, the net position of the Eurosystem in foreign currency (asset items 2 and 3 minus liability items 7, 8 and 9) was EUR 263.9 billion. The ECB is also able to create reciprocal or one-sided swap arrangements with all other serious central banks. As far as I know, the Eurosystem does not have any significant amount of index-linked liabilities.
Hence no imminent ‘Iceland problem’ for the continent: The ECB can always create euro-base money either by issuing additional currency or by increasing euro bank reserves. But it does leave one sore point exposed, as Buiter explains:
[it is] possible that the amount of additional base money that would have to be created to maintain the Eurosystem’s solvency could endanger the ECB’s price stability mandate, operationalised as a rate of inflation, measured by the HICP, below but close to 2 percent per annum in the medium term.
So the question Buiter actually poses is does this leave the ECB with enough capital “to be able to engage in effective monetary policy, liquidity policy and credit-enhancing policy (including quantitative easing or QE), without endangering its price stability mandate.”
Which brings us to the issue of the quality of the Eurosystem’s balance sheet, and the ECB’s recent proposal to begin buying covered bonds as of June in what may or may not be sterilised purchases.
As Buiter highlights, out of all the main central banks in the world, the ECB’s balance sheet is perhaps the one most ridden with ‘rubbish’ assets. Remember, unlike the Fed or the BoE — ECB policy since inception has allowed mortgage-backed securities to be pledged as collateral. Whether they actually were is another matter. Nevertheless Buiter writes:
The Eurosystem already has taken a lot of private sector credit risk exposure on its balance sheet. It accepts as collateral in repos and at its discount window (the marginal lending facility), most private securities (including most asset-backed securities except those that have derivatives as underlying assets) rated BBB- or better. That includes a lot of rubbish. Commercial banks throughout the Eurozone (including subsidiaries of Lehman Brothers and of the now defunct Icelandic banks) have repoed with the ECB. When three banks went belly-up in late 2008, the Eurosystem was exposed to potentially dodgy collateral to the tune of about €10 bn and provisioned about € 5 bn.
With assets of € 1,795 bn and capital and reserves of € 73 bn, the Eurosystem has 24,6 times leverage. A decline of just four percent in the value of its assets would wipe out its capital. That does not look like a terribly comfortable position, as the quality of much of the assets it has accepted as collateral from Euro Area banks is likely to be uncertain at best.
Unlike the US banks and the UK banks, Eurozone banks have barely made a start on recognising the toxic and bad assets they are exposed to, on balance sheet or off-balance sheet.
And while he doesn’t want to single out any particular nations as consecutive abusers, he does infer indirectly by saying:
I won’t this time single out Iberian banks as likely suppliers of vast quantities collateral consisting of dodgy residential mortgage-backed and commercial-mortgage-backed securities to the Eurosystem.
Being given the evil eye by the Governor of the Central Bank of Iberia is no laughing matter. And in any case, the Irish banks are likely to have saddled the Eurosystem with collateral that yields to no other Eurozone nation in awfulness.
We know of the dreadful state of most of the German Landesbanken, the fragility of the bailed-out Commerzbank, the opaque balance sheet of Deutsche Bank, the precarious state of the remaining large listed Benelux banks, the exposure of the Austrian banks to Central and Eastern Europe etc. etc. If any of these banks had good collateral, they would not give it to the Eurosystem. They would sit on it.
Which is a very interesting point, bringing us to Morgan Stanley’s latest note on the ECB’s proposed covered bond purchases. Unlike most of the analyst community who have interpreted the move as the ECB’s stab at some sort of quantitative easing policy, Morgan Stanley’s Elga Bartsch believes it’s not at all about “pumping up liquidity”, rather it’s about lending support to a specific market segment.
As she writes:
Contrary to other central banks such as the Federal Reserve or the Bank of England, the ECB does not view these outright purchases as QE. Instead, the ECB views it as “enhanced credit support” for a particular market segment that is key to funding banks and whose “smooth functioning … is important from a financial stability perspective”.
Hence, the ECB is clearly sticking to its aim to support the bank credit channel. Given that the ECB will likely purchase a good 10% of the overall Jumbo market, a market which has only seen about €18 billion of issuance so far this year, according to our interest rate strategy team, the programme will likely cause covered bond spreads to come in.
That means it’s about stimulating issuance in a currently frozen market, rather than “printing money”– hence the uncertainty over sterilisation.
Remember, as per Buiter’s point, price stability remains the ECB’s greatest concern because it is the area it can least control in a worst case scenario. Furthermore, the Eurosystem has already long been dependent on the ability to pledge mortgage-backed securities as collateral at the ECB — a market which has since dried up on the issuance front.
It can therefore be assumed that through its promise to buy covered bonds, the ECB is actually looking to revive issuance of mortgage-backed securities rather than anything else. It does not want to pump liquidity directly into the system itself. Instead, the ECB wants to act like a wise NGO — you can help the hungry by giving them a bag of rice, but what happens once the food runs out? Much better to support the hungry by helping them plant a field so they can look after themselves in the long run.
If the ECB can get the banks to start issuing much less risky covered bonds again, it might down the road also be able to encourage the banks to start issuing conventional mortgage-backed securities too. If banks can raise cash through traditional issuance, they can revive the flow of money through the system, and better still become self-sufficient at raising capital while simultaneously restocking the banking system with ECB-eligible collateral securities.
This could also be of some help to the ECB too, as Buiter points out:
Even before the Eurosystem starts to buy private securities outright (as it is planning to do with high-grade covered bonds, Pfandbriefe, to the tune of € 60 bn), it is certainly within the realm of the possible (or even likely) that it would suffer losses on its assets of €73 bn or more, before this crisis and this contraction are over.
Of course, he adds the ECB is well placed to withstand those sorts of losses, but that’s not necessarily the case for the ECB’s respective member national central banks:
Admittedly, we have to set against the present value of current and future seigniorage the present discounted value of the cost of running the Eurosystem. The ECB is lean and mean, but many of the NCBs are over-staffed, bloated organisations. I have not been able to find data on the current and capital costs of the Eurosystem, but it seems unlikely to alter the conclusion that with its monopoly of the issuance of currency in the Euro Area, and its tax on eligible bank deposits (aka reserve requirements), the Eurosystem is so wildly profitable that it can withstand very large capital losses on its conventional financial balance sheet.
Nevertheless, stimulating the creation of a new stock of securities that institutions can pledge as collateral will help disperse those losses over the course of the economic decline — like using a filter to slowly clean up and stir a stagnant pool of water (as opposed to just turning on the tap and watching the water overflow in the process).
And so far, as Barclays Capital write, the plan at least seems to have switched on the pump:
Following last week’s announcement that the ECB would acquire “Euro-denominated covered bonds issued in the Euro area”, this week has become the busiest in terms of primary market activity since August 2008. At the time of writing, a total of five new issues had been placed (or were live) on the market, almost doubling this year’s gross supply to ¤14.75bn from ¤8.25bn before the ECB announcement.