Extraordinary Measures
First off, it should be stressed that in spite of the adverse reaction in 'risk' markets to the ECB announcement yesterday, the ECB has in fact taken very significant steps designed to bring the liquidity gusher to bear and ease the banking system's funding pressures.
First of all, there is of course the 25 basis points rate cut, which immediately sent all key Euribor rates down sharply.
However, far more important were the decision regarding the provision of new long term refinancing operations (LTRO's) and the decision to further ease collateral eligibility requirements.
In terms of LTRO's, the ECB has – as expected – announced an extremely long term facility. While ECB president Mario Draghi was eager to stress the 'temporary nature' of this measure, there can be little doubt that all these 'temporary' liquidity support measures are slowly but surely becoming ever more enshrined and are taking on a quasi-permanent character. Whenever an attempt is made to take these measures back, crisis immediately results. Draghi may not yet be fully cognizant of this, but we are looking at an essential feature of the fractionally reserved fiat money system here. It needs to continually inflate, or it dies.
From the text of the announcement:
“In its continued efforts to support the liquidity situation of euro area banks, and following the coordinated central bank action on 30 November 2011 to provide liquidity to the global financial system, the Governing Council today also decided to adopt further non-standard measures. These measures should ensure enhanced access of the banking sector to liquidity and facilitate the functioning of the euro area money market. They are expected to support the provision of credit to households and non-financial corporations. In this context, the Governing Council decided:
First, to conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months and the option of early repayment after one year. The operations will be conducted as fixed rate tender procedures with full allotment. The rate in these operations will be fixed at the average rate of the main refinancing operations over the life of the respective operation. Interest will be paid when the respective operation matures. The first operation will be allotted on 21 December 2011 and will replace the 12-month LTRO announced on 6 October 2011”
(emphasis addded)
Again, the effect of this measure should not be underestimated. One of the main obstacles faced by euro area banks as they scramble to obtain funding and attempt to deleverage in order to reach the mandated new tier one capital ratios (which – according to the latest worthless EBA 'stress test' results - is a less onerous exercise than was hitherto assumed), is that liquid banks and investors have withdrawn unsecured funding from the banks considered to be experiencing liquidity and quite possibly solvency problems.
In many cases it has turned out that selling assets is far easier said than done, as the prices that are likely to be paid will invariably lead to the recognition of significant losses that can only be hidden as long as such assets are neither sold nor written down voluntarily. Thus the banks have been forced to obtain funding in bilateral deals on ever more onerous terms, in most cases requiring very large haircuts (or over-collateralization) and have found it very difficult to engage in strategic long term planning as there are currently only very few buyers of their unsecured long term bonds. In addition, the interbank funding market has dried up as well, with liquid institutions preferring to park their excess reserves with the ECB rather than lending them out, as counterparty risk perceptions remain in red alert territory. So a very long term ECB funding facility certainly removes a lot of pressure.
Secondary Media of Exchange and the Re-Hypothecation Chain
Due to the above mentioned fact that assets pledged to obtain funding are often subject to vast haircuts, a collateral shortage has developed in the euro area banking system, a problem which we have first discussed several weeks ago. This developing collateral shortage put paid to ECB board member Lorenzo Bini-Smaghi's full-throated assurances of a few months ago that 'there is plenty of eligible collateral in the euro are banking system'. In fact, it appears that an amount of € 14 trillion in eligible collateral thought to be available at the time has quickly shrunk to next-to-nothing. Of course this has been further egged on by the Fed's and BoE's 'QE' operations, which permanently remove 'safe collateral' from the marketplace, as well as the constant stream of credit rating downgrades, which make collateral previously regarded as 'safe' decidedly 'unsafe'. In the sovereign bond space in Europe alone, trillions in debt collateral have been pushed into the 'unsafe' category. The effect is that haircuts and margin requirements are constantly increased. In the meantime, more color on this problem has emerged, via the '2012 Global Outlook' recently published by Credit Suisse.
