The below is from the FT’s Money Supply blog that covers on all things central banky. FT Alphaville enjoyed it so much, that we had to ask Claire if we could nick it cross-post. She kindly agreed.
_______________________________________________
So the ECB is offering three-year loans with a cheap interest rate. That sounds like a pretty good deal to me. Where do I sign up?
Not so fast. Only eurozone banks, or in ECB parlance “counterparties”, can get hold of the central bank’s cash.
OK, so say I’m a bank, how much can I borrow?
The sky’s the limit.
The ECB has said the size of its longer-term refinancing operations, or LTROs for short, is unlimited. That means the banks can ask the ECB for as much as they like above the minimum amount of a cool €1m. Most borrowers have tended to ask for something closer to a €1bn.
In times of crisis, cash is king. So what stops the banks borrowing tremendous amounts?
Banks are limited in how much they can borrow by the amount of assets, or collateral, they have that the central bank accepts.
As far as the ECB is concerned, the assets are worth their market, not their face, value. And if the assets fall in value, then the banks must stump up more of them. If there’s no market, then the central bank sets the price itself.
So the ECB’s loans are more like a mortgage, where the borrowing is secured, rather than the sort of borrowing that you do through a credit card?
Yes. This protects the ECB against credit risk. If a bank fails, even though the central bank won’t get its money back from the borrower, then it will have its assets to sell.
The ECB also charges haircuts on collateral of between 0.5 per cent and 46 per cent depending on their quality, which means that for every €1m worth of assets, a borrower will get something between €995,000 and €540,000 in return.
So what collateral does the ECB accept?
Lots. All eurozone government debt is accepted as well as a host of other assets of varying degrees of quality.
Traditionally, the central bank has been far less choosy than either the Federal Reserve or the Bank of England in the collateral it accepts in exchange for its cash. And earlier this month ECB president Mario Draghi said the central bank would relax its terms further to include other assets, among them loans made to small businesses.
So, assuming I’ve got the collateral, and I’m a eurozone bank, how do I go about securing a loan?
Each eurozone bank has two accounts at one of the national central banks that form part of the Eurosystem. One is known as the cash account, where the central bank will deposit cash, the other as the collateral account, where a borrower can park its assets.
If a bank wants to borrow from the ECB, then it bids for funds. But the central bank will only accept the bid if there are enough assets in the collateral account.
Once the central bank has deposited the loan in a bank’s cash account, it will place a block on funds leaving the collateral account.
The value of the assets in the collateral account is calculated daily. If they fall in value, then banks may need to top the account up.
So where does the money for the loans come from?
The ECB creates it by crediting the banks’ cash accounts, enlarging what is known as the monetary base in the process. The creation of the loans is reflected in the size of the ECB’s balance sheet, which has grown significantly since the beginning of the crisis.
Why have these three-year loans attracted so much attention?
For a couple of reasons. First, central banks very rarely offer loans for such lengthy periods of time. In normal, non-crisis, times, three months tends to be the maximum.
Anything longer and the central bank will feel as though it’s doing a job that the financial industry should be doing for itself through the money markets and the bond markets, where banks raise funds. Unfortunately, the markets are all but closed for business at the moment to many eurozone banks because they are seen as being in such poor health.
A lot can happen in three years too. Any one of the 523 banks that have borrowed from the ECB today could potentially go bust. The haircuts and the daily revaluation of the collateral help protect the central bank from a loss if that were to happen. But there’s still a risk that the central bank won’t get its money back.
Then why is the ECB bothering to do this?
The clue lies in Banque de France governor Christian Noyer’s recent comments.
That the UK should be downgraded before France is?
No. Mr Noyer also said that the ECB sees the offer of three-year loans as its “big bazooka” to ease the pressure on eurozone states such as Italy.
Rather than the central bank having to buy Italy’s debt itself, right?
Exactly. The ECB hopes that the banks will use the €489bn to buy sovereign bonds, which would lower the price that the likes of Italy pay to borrow and, in turn, remove pressure on the central bank to step up its debt purchases.
That’s one of the reasons equities initially surged on the news that there had been high demand for the ECB’s cash.
The ECB will also hope that the loans spur lending to businesses and households.
That sounds rather like quantitative easing…
If banks did go out and buy government debt, then it would essentially be a rather indirect way of doing quantitative easing. But that’s a big if.
Will it work?
Only time will tell. Banks may not necessarily use the euros to buy government debt. They may not even lend more.
With many banks struggling to find funding from sources other than the ECB, they might just park the cash on their balance sheet. But that would still help because they then wouldn’t be under so much pressure to deleverage.
Related links:
The ECB’s all you can eat cheap money buffet – a primer – FT Alphaville
LTRO use at €489.19bn - FT Alphaville
Citigroup Analyzes The Failure Of The LTRO, Muses On The Upcoming French Downgrade – Zero Hedge
What Today’s Massive ECB Liquidity Operation Actually Means – Business Insider
The ugly side of ultra-cheap money – Bill Gross, writing in the FT