Europe's Banks to Repay Loans Early. Good News or Not?
Research teams across Europe are busy estimating the size of the repayments the European Central Bank will accept next week on the long-term refinancing operations, or LTROs, that banks borrowed last year. I think they're asking the wrong question.
Much more important is whether repayment will be positive or negative for the euro area, and both are possible.
Just to recap: The ECB’s three year LTROs served as a sugar hit for the euro area’s markets at the end of 2011 and beginning of 2012. Borrowing costs for euro area banks and their sovereigns were on a seemingly endless upward march, and many investors worried that the banks would be unable to roll over the whopping 503 billion euros of maturing debt in 2012. So, the central bank stepped in.
The injection of liquidity that followed amounted to nearly 1 trillion euros. It helped the banks to meet their refinancing needs, and in doing so took the failure of a major European bank off the table.
The LTRO gambit had a double benefit, because domestic banks used the extra liquidity to lend to their governments, relieving pressure on them as well. The banks bought domestic sovereign debt that yielded more than the ECB loans.
The ECB will announce the size of repayment that the banks can make tomorrow. There are many reasons to view the move as a positive signal for the region. First, who would have guessed just over a year ago that Europe's banks would be in any state to participate? When the first of the central bank's two three-year LTRO issues was announced, many people worried about what was going to happen three years later, when banks still reliant on the ECB money suddenly had to pay it all back in one go.
Second, early repayment also indicates that banks are weaning themselves off ECB funding and can raise money in the markets. In the past few months, Banco Espirito Santo and Caixa Geral de Depositos in Portugal, as well as Bank of Ireland and Allied Irish Bank, have succeeded in returning to the private markets for funding.
Plus, early repayment will reflect well on the financial health of the governments, suggesting that they no longer need ECB-fueled bond purchases to raise funding.
But there's also a potential downside of early repayments. Banks could face a tougher operating environment if they give up liquidity prematurely: Weaker banks may feel peer pressure to look strong by making repayments they can't really afford, and if banks have to substitute what they repay to the ECB by borrowing in the market, they'll generally pay more, eating into their profits or increasing their losses.
Banks’ access to the markets is dependent on positive market sentiment of the kind we have seen since last summer, when ECB head Mario Draghi said he would do “whatever it takes” to preserve the euro. Such positive market sentiment is far from assured. The chances are that investors will begin to worry about European banks and their sovereigns as the recession continues to deepen in the euro area. If banks have repaid their central-bank borrowing and find themselves suddenly shut out of the markets, they will have trouble refinancing their debt this year. For the euro area as a whole, that amounts to 557 billion euros, even higher than last year.
Finally, early repayment of the three-year LTROs could remove downward pressure on the short-term interbank rates that commercial banks rely on to fund themselves on a daily basis. If banks rush to return their excess liquidity to the ECB, that downward pressure disappears and interest rates could rise.
Those are potentially grave risks -- but don't worry too much. If any one of them materializes, the ECB will surely step in to reverse it, most likely with more LTROs.