The success of the European Central Bank’s (ECB) three-year long-term refinancing operation (LTRO) in averting a liquidity-driven crisis in Europe’s banking sector is unquestioned. However, as its effects start to fade, more concerns are being raised about the levels of encumbrance that have built up on many eurozone bank balance sheets as a result of their cheap €1 trillion funding spree.
“Collateral used in ECB operations is marked to market, whether it is traded or not,” explains Guy Mandy, rates strategist at Nomura in London. “This includes the additional credit claims, which were added to the ECB’s eligible collateral list.
“The widening of sovereign debt yields and increasing level of non-performing loans in the periphery is a very worrying development. Banks using these debt securities and loans as collateral will in all likelihood be experiencing margin calls.”
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| “The emphasis is now moving from the eurosystem to sovereign treasuries, which is an unfortunate move by the ECB” Guy Mandy, rates strategist at Nomura in London |
This issue of encumbrance is one that has attracted growing attention in recent months – particularly due to its likely dampening impact on bank funding for the rest of the year.
And due to the design of the ECB collateral haircuts themselves, this problem of convergence is actually encouraging banks to buy more sovereign debt to substitute it for the more punitively treated collateral that their LTRO loans are written against.
“One reason why banks have gone out and bought sovereign debt is in order to reduce their asset encumbrance,” says Mandy. “They could do this by buying sovereign debt and substituting it for lower-quality collateral, which is subject to higher haircuts. This releases balance sheet.”
According to an indicative example from Nomura, if Step 4 (BB plus to BB minus) loan collateral for €100 million ECB funding is replaced with sovereign debt of a similar one to three-year maturity, the weighted average haircut applied changes from 62% to 2.9% and the amount of collateral pledged falls from €161.3 million to €102.4 million.
This might go some way to assuaging the pressure that balance sheets are under, but it has the unfortunate effect of further strengthening the links between banks and their sovereigns at a time when the ECB should be doing all it can to delink the two as much as possible.
The systemic risk that the huge pool of collateral pledged against ECB lending now represents could soon be graphically illustrated if other rating agencies follow S&P’s recent lead and downgrade Spain.
If a sovereign is downgraded and moves into the ECB’s Step 3 bucket – which includes collateral rated BBB plus to BBB minus – then there is a 5% across-the-board additional haircut for all maturities.
If all three rating agencies move Spain to BBB plus, as S&P recently did, then Spanish collateral will move into the Step 3 bucket and be subject to this additional haircut. The implication for the Spanish banks is serious indeed (see chart).
| Cumulative change in Spanish bank holdings of sovereign debt since January 2011 |
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| Source: Nomura |
Concerns about collateral implications have prompted some core central banks to push for the ability to disallow assets from programme countries. The Austrian Central Bank (Oesterreichische Nationalbank) and Germany’s Bundesbank announced in early April that they will no longer accept as collateral bank bonds guaranteed by member states receiving aid from the European Union and the International Monetary Fund.
“The ECB can run negative equity if it wants to but sovereign central banks have lower flexibility in this regard and rely on their treasuries for capitalization,” Mandy explains.
“The emphasis is now moving from the eurosystem to sovereign treasuries, which is an unfortunate move by the ECB. It leads to the disaggregation of eurosystem risks when the ECB should be creating a stable system.
“The euro area has €6 trillion of sovereign bonds outstanding, only €1 trillion of which are German. With the push to have central counterparties, the continued requirement for secured funding and lending, to mention a few, there will likely be a huge collateral squeeze.
“One way for the ECB to provide some relief could be to create debt certificates to absorb current excess liquidity, which is seeking a deposit of at least a week. This can be seen in the amount bidding for the one-week deposit facility linked to the ECB’s Securities Markets Programme sterilization operation.”
