Analysis – LTRO will not help the real economy but prolong speculation

2012-03-04

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A few days ago the European Central Bank launched its second round of three year loans to private banks at 1% interest rate, under the so-called Long Term Refinancing Operation (LTRO). This second round of LTRO loans attracted funding requests from 800 banks, bringing the total supplied amount to €529.5 billion. Combined with the first round of the programme, the amount of funds loaned by the ECB are around €1.02 trillion. The fact is that this massive injection of liquidity in Europe’s quasi bankrupt banking system, has prevented an immediate financial crisis and has bought enough time for policy-makers to bring their houses in order and push for concrete solutions to the ongoing crisis.

Several analysts believe, or want to believe, that the LTRO will ultimately provide much-needed liquidity to the real economy, allowing for increased business activity that will stimulate demand and thus kill off the recession, leading back to recovery. Having followed the eurocrisis for months now (I was speaking about Europe’s bankrupt banks since almost a year ago) I may say that the LTRO will not help the real economy, since the given conditions provide no incentive to banks to issue loans to firms and individuals. Instead banks have a series of very good reasons to invest in sovereign bonds, thus prolonging the stress in the real economy.

The reasons banks will not be willing to issue loans are three. Namely the bank recapitalization programme, the criteria of the ECB for new loans, the high risk that loans have contrary to sovereign bond purchases. Analyzing each of these will make my point clear and will allow the reader to understand that this new bank bailout (LTRO is a euphemism) will only buy time for politicians at the cost of more speculation from bankers.

First, the bank recapitalization programme. In the October 26-27, 2011 European Council Summit, the heads of state or government of the European Union agreed to formulate a programme under which banks are asked to raise their capital ratio from 8% to 9% until June 30, 2012. A one percent increase might indeed sound marginal and ancillary, yet when speaking of billions it is not; let alone the fact that few banks were at the 8% target.

For banks to meet these conditions there are three possible courses of action: (1) bring down total risky assets while keeping the available Core Tier 1 capital constant, so that the denominator decreases, while the numerator stays the same, thus increasing the ratio, (2) issue shares, offering the opportunity to new investors to come in, at the potential cost for the banker of losing control of his/her bank, (3) buy sovereign bonds that comply with the criteria set by regulators to count as Core Tier 1 capital, in order to directly increase their capital.

If the ECB had not provided any support to the region’s banks, they would be forced to cut expenses and reduce their openings (deleverage), while keeping their core capital constant, and/or they would issue shares to attract fresh capital, always at the risk of losing control of the bank to the new investors. The option of buying sovereign bonds would have been extremely hard to reach, given that most banks were short on funds, therefore not allowing them to make such investments (“investments”). By launching the LTRO the ECB has offered the chance to banks to avoid the tough choice of reducing their activity and/or issuing shares, by providing them with the funds they need to buy sovereign bonds. By acquiring the sovereign bonds of countries like Italy and Spain (or other like Germany), banks increase their Core Tier 1 capital, since these bonds meet the criteria set by regulators in October, 2011. In a nutshell the bank recapitalization programme, in conjunction with the LTRO provide the incentive to banks to buy sovereign bonds of particular countries, instead of issuing loans to the real economy.

Second, the criteria of the ECB for new loans. The ECB maintains a policy of accepting as collateral for the issuance of new loans, sovereign bonds that again comply to a given set of conditions. In practice a bank that has Italian bonds can offer them to the ECB in exchange for a new loan. Taking into account the fact that most sovereigns are in desperate need of loans (sell their bonds), to cope with the mounting pressures of the debt crisis; while also considering the sufficient profit margin that exists between the 1% loans of the ECB and the 5% or 6% (or more) rates of certain sovereign bonds, banks have every reason to buy these bonds, enjoy the profits and then offer the bond back to the ECB in order to restart the speculative process.

Again the point is that there will be an interplay between states and banks, whereby banks will be the ultimate winners as they will make considerable profits, while the real economy will remain short of liquidity; as again there is no real incentive for banks to issue loans, amid such uncertain conditions, especially when the secure option of sovereign bonds exists. After all buying such bonds also serves the banks needs with respect to the recapitalization programme, as explained above.

Third, the risk in issuing loans is much higher than in buying sovereign bonds. The actions of policy-makers all these crisis years have manifested an unprecedented determination to prevent sovereign defaults – and even bank failures – at all costs. All know about the massive bailouts to banks at the beginning of the crisis, followed by bailouts to bankrupt states, again for the sake of preventing a financial meltdown (the talk about “solidarity” is nonsense). Considering that politicians will go to any length in setting up “safety mechanisms”, it is safe to conclude that a banker will have good reason to bet on this, by speculating on sovereign bonds. The perverse incentives that bailouts produce are indeed numerous, yet the gist is that the underlying malignancies are not addressed, while speculation is in fact encouraged and reinforced.

While sovereign bonds are indeed protected by all sorts of mechanisms and interventions, ultimately making the investment quite safe, the loans to the real economy are not – and cannot – be guaranteed by any authority. Given that the real economy is still in a recession and after taking into account the fact that many loans might not be paid back, why would a bank get in such a trouble, when it has the safe (and profitable) option of purchasing sovereign bonds thus accomplishing three things in one: comply with the recapitalization criteria, have the chance to get more ECB loans, minimize risk. So again it becomes evident that there is no real incentive for banks to provide liquidity to the real economy, but instead speculate on sovereign bonds.

After taking all the aforementioned into account, it becomes crystal clear, to me at least, that the LTRO funds will not reach out the real economy, or if some of them do, the total effect will be negligible, since the vast majority of the funds will be directed to sovereign bond purchases. And of course states will use those funds to cover their immediate expenses and most importantly pay back their older debts (to these same banks). Banks have very strong incentives to buy such bonds, while there is nothing really that would make them provide much needed liquidity to the real economy. I myself am convinced that regulators were fully aware of all the above and everything has been planned from beginning to end for one single reason: to bring down the yields on Spanish and Italian bonds, in order to show that the new governments’ efforts are effective, with the hope of restoring confidence in the markets, about the capacity of Europe to deal with its crisis. Though this could indeed be a rational plan (a trick) to get out of the crisis without making real reforms in the institutional framework of the euro and the EU and without addressing the flaws of the single market; I am afraid to say that the markets are also aware of what is happening and will abuse all the loopholes with impunity. For the months ahead we will see the spreads on Italian and Spanish bonds falling and we will hear the well known rhetoric of European leaders over how successful their strategy has been. However once the artificial money bonanza is over, expect to see a repetition of the shadow play we have been witnessing all these years.

Oh and needless to remind you that when money was given to states, harsh austerity and loss of sovereignty were among the preconditions…