LTRO has exacerbated systemic risk – Draghi did not reverse the crisis

This post is archived. Opinions expressed herein may no longer represent my current views. Links, images and other media might not work as intended. Information may be out of date. For further questions contact me.

Lately I came across quite a few articles and podcasts explaining just how great Mario Draghi, the chief of the ECB, is; and how his two tranches of Long Term Refinancing Operation (LTRO) loans to Europe’s quasi-bankrupt banks, at just 1% interest, worth €1.02 trillion, killed off the crisis. The authors were basically saying that Mario Draghi used his big guns to inject so much liquidity in the Eurozone that he effectively managed to convince even the most reluctant investors that the crisis is over. It is the standard something for nothing rhetoric, according to which all the economy needs is some wise man in the bowels of a central bank to turn on the printing press and make people richer without anyone becoming poorer. And though “free lunches” of that sort are served quite often by regulators, supported by an army of ignorant opinion-makers; this particular “meal” might indeed bring “food poisoning” to the European economy.

As explained in previous articles on the LTRO, the programme has practically forced banks to buy sovereign bonds as if there was no tomorrow. Italian and Spanish bonds benefit the most, without excluding French or EFSF bonds (or others). This is clearly reflected in the falling borrowing costs. In other words the LTRO, in conjunction with the capital adequacy requirements, created artificial demand for these bonds, since in truth the underlying economic reality did not change at all, as growth prospects did not improve, deficits were not reduced, debts did not become sustainable, unemployment was not addressed, aggregate savings did not increase and so on so forth. Nothing really changed apart from the fact that banks were handed with oceans of cheap cash to either hoard it or speculate against states (taxpayers).

Apart from the short-term relief in the capital markets, the LTRO has only succeeded in channeling resources into potentially toxic investments, ultimately strengthening the negative feedback loop between stressed sovereigns and quasi-bankrupt banks. Systemic risk is exacerbated as banks are now more exposed than before to a possible sovereign debt crisis, sovereign default or sovereign debt restructuring. Meanwhile the structural payment imbalances through TARGET 2 remain unsettled and unchecked, with whatever that may imply when it all comes down to financial contagion.

Yet the adverse effects of Draghi’s money-printing bonanza are not be limited to systemic risk, but expand to the very robustness of the banking sector. With the cheap LTRO loans flooding the system, bankers have little to no incentive to proceed with adjusting the balance sheets of their banks. As such much of the zombified portion of the banking system will remain in the same position, perpetuating its half-dead-half-alive condition. The LTRO is but another step in the Japanification of the European banking system; while the role of the ECB as lender of last resort has changed in two ways: (1) the ECB has become a dealer of last resort in capital markets effectively stepping into the realm of fiscal policy, (2) while at the same time it has become the lender of first resort for many of the continent’s banks. This ultimately implies that the ECB is losing its independency and is distorting its normal function.

The free lunches that the ECB has been delivering these last months, have done nothing at all to mitigate the crisis. To the contrary there are many indicators in place suggesting a further erosion of the ECB’s independence and a further distortion of its original role in the system. Draghi did not kill off the crisis, nor did he deliver something for nothing. Instead the underlying malignancies at national and supranational level together with the stress in the financial system, all remain in tact, while systemic risk has actually increased. I really hope that everything goes well and we do not see any deterioration in countries like Spain, as then I am not sure what kind of exit plan the ECB or indeed the rest of the Eurozone/EU has. The crisis is definitely far from over.