The ECB’s Mario Draghi gave a speech to the European Parliament on Thursday, making some of the following key points:
RTRS – DRAGHI-DOWNSIDE RISKS TO ECONOMIC OUTLOOK HAVE INCREASED
RTRS – DRAGHI-ECB TEMPORARY MEASURES ONLY LIMITED
RTRS – DRAGHI-ECB AWARE OF CONTINUING DIFFICULTIES ON BANKS
RTRS – DRAGHI-AWARE OF MATURITY MISMATCHES, STRESSES ON BANK FUNDING
RTRS – DRAGHI-CHANGES IN STRAINED COUNTRIES HAVE NOT YET HAD IMPACT ON FRAGILITY OF FINANCIAL MARKETS
RTRS – DRAGHI-CREDIBLE SIGNAL NEEDED TO GIVE ULTIMATE ASSURANCE OVER THE SHORT TERM
Another point also raised (but not flashed by Reuters for some reason) was that authorities are aware of the scarcity of eligible collateral in some financial segments. This in our opinion is a key issue and one which cannot easily be fixed by ECB purchases.
As Draghi noted:
Dysfunctional government bond markets in several euro area countries hamper the single monetary policy because the way this policy is transmitted to the real economy depends also on the conditions of the bond markets in the various countries. An impaired transmission mechanism for monetary policy has a damaging impact on the availability and price of credit to firms and households.
Furthermore, it echoes Draghi’s comments from November 18, when he said:
We are aware of the current difficulties for banks due to the stress on sovereign bonds, the tightness of funding markets and the scarcity of eligible collateral. We are also aware of the problems of maturity mismatches on balance sheets, the challenges to raise levels of capital and the cyclical risks related to the downturn.
In the money market, we see rising spreads between secured and unsecured segments, and a widening of repo prices between different types of collateral. Interbank activity remains subdued and concentrated in the very short-term maturities. This limited activity is reflected in increased recourse to our liquidity-providing operations, as well as to our deposit facility.
He’s trying to get a point across. Not only is the ECB arguably losing control, it’s trying to flag up that the chaos is the result of messed up transmission mechanisms in dealer markets more than the result of a changing view of Eurozone credibility.
No wonder the reaction in the German bund market has been as follows:
RTRS-GERMAN 5-YEAR GOVERNMENT BOND YIELDS FALL 6 BPS ON DAY TO 1.113 PCT
RTRS-GERMAN ONE- TO SIX-MONTH GERMAN TREASURY BILL YIELDS DIP FURTHER INTO NEGATIVE TERRITORY AFTER DRAGHI COMMENTS
Even if the ECB broadens the criteria on the collateral it acccepts — and remember it already accepts some of the poorest quality collateral in central banking circles — that won’t necessarily solve the problem in the public bilateral markets where only top quality bonds will do. And it’s what is happening in the bilateral and interbank markets which is determining the fate of the eurosystem.
Which brings us to this new paper from Manmohan Singh, an IMF economist, about the velocity of collateral, as picked up by Marginal Revolution. Specifically this chart, which sums up all the players affected:
He stresses the importance of the dealers in that relationship, who are finding it ever harder to make markets due to market dysfunctions:
Large dealers are incredibly adept at moving collateral they receive that is pledged for re-use. The “velocity of collateral”—analogous to the concept of the “velocity of money”—indicates the liquidity impact of collateral. A security that is owned by an economic agent and can be pledged as re-usable collateral leads to chains. Thus, a shortage of acceptable collateral would have a negative cascading impact on lending similar to the impact on the money supply of a reduction in the monetary base. Thus the first round impact on the real economy would be from the reduction in the “primary source” collateral pools in the asset management complex (hedge funds, pension and insurers etc), due to averseness from counterparty risk etc. The second round impact is from shorter “chains”—from constraining the collateral moves, and higher cost of capital resulting from decrease in global financial lubrication.
In the U.S. and Europe, both the Fed and ECB consider many information variables when determining monetary policy. The monetary base or M2 is an integral part of the “orthodox” monetary tool-kit where the velocity of money is considered as either constant or stable.13 The ECB still uses this metric and both the U.K. and ECB also publish the M3 measure.14 After Lehman, since there has been a move away from the strict Taylor rule, we look at alternatives to augment the traditional metrics. We suggest that the traditional monetary indicators be augmented by including collateral that large banks in the U.S. and Europe pledged for reuse with each other. There are links between pledged collateral that is intermediated by large banks and “quantitative” monetary policy instruments. We find that post-Lehman counterparty risk and related issues led to a significant drop in pledged collateral among the major U.S. and European globally active banks. Overall, global liquidity remains below pre-Lehman levels when we consider collateral use/reuse along with M2 (see Figure 5).15 This stems from a decline in both the collateral that is pledged for re-use and the associated churning factor.
Add to that the fact that only those banks which hold surplus reserves at the central banks are the ones that are really able to operate in the short-term unsecured markets, with everyone else pretty much called up for collateral, and suddenly the collateral crunch makes an awfully big difference to everything.
As Marc Ostwald of Monument Securities noted on Wednesday:
Secondly, while the sense that central banks will ostensibly do anything to ensure no “meltdown”, the implication that central banks appear to be willing to expand their balance sheets ad infinitum (ad nauseam? Ed.) begs 2 questions: a) at what point do they become the “central counter party” for the interbank market, which would infer a terminal breakdown in the ‘interbank market’, and b) central banks, either collectively in the ECB’s case, or individually elsewhere, are implicitly backed by national governments. So if they are per force of events expanding their balance sheets exponentially, and the world is worried about the level of government debt and budget deficits, then why should there actually be any sense of comfort from this action, and beyond that, is this not just another example of money’s role as being a proxy for a store of value (but having no intrinsic value of itself) being destroyed?
And that’s the problem the ECB has. Anymore purchases or provision of liquidity against existing collateral just encumbers ever more of it at the ECB pawnshop.
It might therefore have to do an RBA, and manufacture quality collateral out of the blue. Not sure how, though.
Euribor has been vaporised – FT Alphaville
On the perils of plunging repo rates – FT Alphaville
When a government bond becomes a Giffen good – FT Alphaville
One Eurobond to rule them all – FT Alphaville
Financial system creaks as loan lubricant dries up – FT