Nomura on Draghi’s failure to address the collateral problem | FT Alphaville

Nomura on Draghi’s failure to address the collateral problem

There are a growing number of voices suggesting that much of the Eurozone funding crisis could be simmered by addressing one of its most identifiable symptoms. The quality collateral crunch in the system.

As we’ve noted before, there are many reasons to think that the trend towards ‘quality’ collateralised funding is having as much of an impact on the valuation of bonds in both private and central bank funding markets, as the perception that European sovereigns might be insolvent.

Given that fact, the likes of Nomura’s Guy Mandy, as well as Christian Hellwig Professor of the Toulouse School of Economics and Thomas Philippon of the Stern School of Business, NYU writing on VoxEu, believe a credible solution that could help soothe funding tensions — at least in the immediate future — would be the decision for the ECB to issue ECB bills or for Treasuries to unite in the issuance of Eurobills.

The idea — similar to the Fed’s cooperation with the Treasury in its Supplementary Financing Progamme — would be to provide the collateral markets, which are crying out for investable high-grade securities, with a form of positive-yielding and collective eurozone ‘quality’ asset.

Needless to say, Draghi failed to announce any such measures this week, a fact which could disappoint collateral markets, according to Mandy:

Changes to the ECB’s extraordinary measures fell short of improving the level of high quality eligible collateral and solving other issues such as unproductive excess reserves that we had hoped for.

That said, there are some measures which could be considered helpful, among them the option to pay back long term funds after one year and the improvement on the breadth of eligible collateral for public repo.

As Mandy explains:

The changes are marginally positive however, with further improvement on the breadth of eligible collateral for public repo, particularly in the case of ABS for peripheral banks. There was a noticeable lack of action on haircuts on sovereign bonds, though if this were to occur it would be unlikely to occur before a “fiscal compact” is reached amongst European politicians.

The dropping of the reserve ratio from 2% to 1% is positive for weak banks, but will likely increase cash on deposit with the ECB from strong banks.

The new 3yr LTRO, with a 1yr payoff option is also a positive move and we would expect a large take up at this operation. The additional liquidity will boosts banks’ solvency, from a liquidity stand point rather than balance sheet solvency.


The flexibility of early repayment after one year, effectively an American option, is very valuable. This means that ‘if’ the sovereign stress/economic situation improves to a point where unsecured funding becomes the normality rather than the exception collateral isn’t encumbered for the full three years. At the same time if the European economic backdrop improves and inflationary pressures rise coupled with the ECB increasing the policy rate institutions are not locked into paying a rate which is indexed to this policy rate.

As regards the removal of fine tuning operations, this proves interesting only in that it shows that the operations have now become useless at trying to influence Eonia, which is continuing to trade at a signifcant spread to the policy rate.

On the reserve ratio cut, meanwhile, Mandy is of the opinion that while it might help the weak banks in the system, it may do little to discourage the liquidity hoarding behavior of the larger institutions:

The ECB is lowering the required reserve ratio from 2% to 1% from 18 January 2012. The cutting of reserves leads to a lower mandatory pull of cash into the ECB through the reserve maintenance period (average reserve requirement for current maintenance period is €207bn), which is positive for weaker banks. The reserve requirement is based on the level of short term liabilities at the end of the month two months prior to the maintenance period. In times liquidity/credit crises short term liabilities tend to go up, with this generally being more acute for weaker banks.

As it is a lagging calculation, we may have just started seeing the incremental add over the next few periods. So the dropping from 2% to 1% should cushion this rise While the requirement reduction will leave more cash in the system, the excess liquidity increase via strong banks is still likely to be put on deposit with the ECB, while the financial system remains stressed.

Which is why, from the perspective of the collateral markets at least, the best move would have been the announcement of ECB bills, says Mandy.

In our view, a complementary solution to the high quality collateral shortage for private repo and the reduction of unproductive excess reserves would be to issue ECB bills. This provides a liquidity drain as well as high quality collateral.

Net net we think the ECB missed a crucial opportunity to provide a solution to the acute shortage of high quality collateral in the European private repo market, the details of which we outlined in our note on Monday.

Conclusion: it’s a Draghi fail.

Related links:
On the ECB’s ‘most significant non-standard measure’ – FT Alphaville
One Eurobond to rule them all
– FT Alphaville
The German bond market is all about ‘buy and hold’
– FT Alphaville