Monday, 28 May 2018

Could free ECB money have expensive consequences?

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IFR editor-at-large Keith Mullin picks through the dangers of the ECB’s cheap money

IFR Editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

ECB EXECUTIVE BOARD member Benoit Coeure has provided an interesting counterbalance to Mario Draghi’s recent and in my view rather overdone “statements of virility” jibe of a couple of weeks back.

In a speech that the ECB posted on February 24, Coeure pointed to a series of potential risks arising from the central bank flooding the system with ultra-cheap cash and bringing about prolonged periods of low interest rates. He also brought up the thorny issue of ECB action getting banks hooked on the rush of unlimited cheap cash.

If you recall, Joe Ackermann recently said that Deutsche Bank might not tap the three-year LTRO facility because of the stigma attached. Draghi went on the attack, denouncing such comments because he reckoned they undermined the central bank’s role in promoting financial stability in the eurozone. I always thought Draghi’s comments were inappropriate.

While Coeure acknowledged that there is no technical bottom to central bank funding rates, he warned that zero or negative interest rates could have long-lasting implications for banks and their trading incentives.

“In theory, everybody would love to borrow at zero or negative rates without going through the pain of finding a creditor happy to take the opposite side of the transaction,” he said. “If the central bank offers this service systematically, banks can dismantle their trading platforms – which are costly to maintain – and become addicted to central bank credit.”

He continued: “If a protracted period of zero or negative interest rates were to be experienced in the euro area, it would be particularly important not to lose the perspective, and the possibility, of restarting the interbank market at a later stage. The intermediation role taken by the central bank cannot, and should not forever take the place of money market activity.”

He makes some good points. The LTRO and other ECB operations have clearly played a role in calming frayed nerves around the stability of the banking sector. But I guess the questions that arise are: Can there be such a thing as too much free money for too long? How do you wean banks off the drugs? What risks are there to shock withdrawal therapy and the danger of leaving a vacuum?

The nirvana of unlimited free money has a flip side when the taps are turned off

MONEY-MARKET RATES at their lowest level for over a year suggest interbank markets are normalising. Three-month Euribor fixed at 1.006% on Friday, a level not seen since January 14 2011 and compared with 1.343% at the beginning of 2012. Three-month Euribor futures point to a decline to around 80bp by year-end. But overnight deposits at the ECB are back above €500bn, suggesting markets are still far from functioning normally.

The nirvana of unlimited free money has a flip side when the taps are turned off that could lead back to exactly what Draghi railed against so clumsily the other week with his virility comment.

Banks that struggle to access funding in an otherwise stable borrowing environment are likely to be ostracised by risk-averse counterparties. And you know what? In an efficient marketplace, stigma around the weaker links in the money supply chain which have no recourse but to tap the central bank for funds is arguably a good thing, unless the expectation is for an interventionist ECB standing in perpetuity with its interest-free cheque book at the ready.

In the meantime, drowning the system in cheap cash could drive money-market funds out of business because it undermines their business model and encourages investors to shift their investments to alternative, more profitable, segments.

Coeure believes low rates can undermine the profitability of commercial banks on the basis that deposit-flight risk could compel them to keep depo rates at current levels at the same time as lending rates are falling, leading to a negative loan-deposit spread, which in practice means credit to the real economy will contract.

AND SO TO THE TOPIC that gave rise to the LTRO in the first place. Having written so much about the Greek debt situation in the past 18 months, I couldn’t pass up the opportunity to comment now that a deal has been inked.

It’s amazing how little reaction there was when the white smoke blew above Brussels during the course of last week. Terms of the bond swap were more or less as telegraphed, albeit with a slightly deeper haircut. There was some sniffiness around, about the intrinsic value of the GDP-linked value recovery rights, but in truth, they’re more of an arcane curiosity than anything that will bring in or drive away interest in the deal.

There will be hold-outs, but it’s clear that some investors are choosing not to go into the deal purely because tendering into the swap kills their chances of getting paid out at par and destroys any negotiating power they might dream up. The inevitability of being coerced through CACs means the very worst they will get are the terms everyone else gets. That fall-back option removes any incentive to tender.

Changes to Fitch’s Greece rating, the timing of CDS being triggered, and the notion of private-creditor subordination created by the ECB declining to take losses all added to the general cacophony, but the reality that drove sentiment during the week is that no-one believes the second €130bn bailout will be the last.

Greek finance minister Evangelos Venizelos put it very well: “To succeed,” he said, “we need to be united, serious, trustworthy, persistent and to work, work, work.” How can I put this? Zero out of five ain’t gonna get you there.

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