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Monday, 11 December 2017

The ECB liquidity conundrum

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IFR’s Divyang Shah asks: Is the decline due to less fragmentation or deleveraging?

Divyang Shah, Columnist

Divyang Shah, IFR Senior Strategist

One of the key questions the ECB is asking itself is how much of the decline in excess liquidity is as a result of a reduction in fragmentation and how much is due to deleveraging by banks. This is an important issue, as evidence that deleveraging is playing a critical role would be sufficient for the ECB to take action and deliver another LTRO.

The ECB’s policy meeting early this month did much to communicate that it is being “particularly attentive” to the decline in excess liquidity. The ECB has been keen to play up the reduction in excess liquidity as coming on the back of increased confidence and a reduction in fragmentation, although the bank is far from certain that these positive factors alone explain the fall.

ECB Executive Board member Praet said in an interview published Sunday that it remained to be seen whether 3-year LTRO repayments were due to banks shrinking their balance sheets and reducing lending to the economy. This the ECB sees as a de facto tightening of monetary policy, and if indeed deleveraging is behind the reduction in excess liquidity, then Praet says the ECB “stands ready to take action if necessary”.

Even if the reduction in excess liquidity is viewed in a positive light, the ECB views movements in short term money market rates as “unwarranted”. This in itself suggests that we are closer to some form of action, with the force of that action likely determined by the extent to which bank deleveraging is impacting excess liquidity.

We continue to see the ECB move toward providing another LTRO, with:

1) a 3-5 year maturity,

2) a fixed or lower rate throughout the life of the LTRO,

3) to include ABS on SME loans, and

4) to come in conjunction with changes to the collateral framework.

With the data coming in more positive, the ECB has to make sure that any stimulus is packaged as providing the infant recovery with continued support.

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