Leaks in the ECB's liquidity plan

By doling out cheap liquidity just before it tests the integrity of bank balance sheets, the ECB may end up propping up the very institutions whose weaknesses it is trying to uncover.

The European Central Bank’s dilemma over the potential need to extend long-term liquidity to banks is proving an early test of the conflicting pressures it will face in combining the roles of monetary policy guardian and chief bank supervisor.

The arm of the bank that will oversee the currency bloc’s banks in one year’s time is preparing for its duties by conducting a health check on balance sheets of the biggest 128 lenders in the eurozone. Mario Draghi, president, has promised that these will be rigorous and officials will be prepared to fail banks.

At the same time, policymakers in the core monetary policy function of the bank have been considering what to do about short-term interbank interest rates creeping upwards as well as the maturity in early 2015 of its own long-term refinancing operations, which offered banks €1trillion in cheap liquidity.

A sharp rise in short-term rates deters lending, hurting the economy and pushing already too-low inflation lower. It also cuts against the bank’s decision to keep its main refinancing rate at or below its current record low for an extended period. Some banks have compared the maturity of the LTROs to a “cliff”, putting further upward pressure on short-term rates. The obvious answer then would be to issue new LTROs in some form. As Draghi said this month: “Nobody wants a liquidity accident occurring between now and the recovery”.

But hereinlies the tension. By doling out cheap liquidity just before it tests the integrity of bank balance sheets, the ECB may end up propping up the very institutions whose weaknesses it is trying to uncover. Weaker banks, particularly in the stressed countries like Spain and Portugal, may take up the new LTROs and then buy better yielding sovereign debt from their home countries - exactly the outcome nobody wants.

This is one reason why the bank is not rushing to renew the LTRO programme.

The “cliff” problem in 2015 may also turn into more of a molehill as it comes into view. The ECB’s latest quarterly bank lending survey showed that in aggregate, the 133 banks surveyed did not cite their liquidity position as a factor preventing them from lending, and this situation had improved.

Cost of funds and balance sheet constraints actually contributed on average to a slight net easing of credit standards for loans to companies in the third quarter, the first time it has done that since the third quarter of 2009. Although, taking other factors into account, the overall picture is still one of a net tightening in credit standards.

The aggregate picture in the lending survey may well conceal sharp regional differences. But from a purely monetary policy standpoint, the bank could take the view that overall there is no liquidity problem and, if a handful of banks in periphery economies have a problem, so be it.

Still, the measure of excess liquidity in euro area money markets has been falling as banks pay back the LTROs early. On Tuesday it stood at €173 billion, below the €200 billion level that Draghi identified in February as a level that would cause short-term rates to rise – a prediction he more recently backed away from, saying it depended on the context.

An appreciating euro and the possibility of the US Federal Reserve phasing out its asset purchases both add to the upward pressure on eurozone money market rates. So the bank might also consider alternatives to a new LTRO. It could cut its reserve requirements, although no bank official has raised this option. More likely would be for it to extend its so-called fixed rate full allotment operations.

Its final option would be a good, old-fashioned interest rate cut, taking the refinancing rate below 0.5 per cent and either keeping its deposit rate at 0 per cent or adopting its first ever negative interest rate. The bank’s council has been divided over whether this is even worth discussing given the Eurozone’s nascent recovery. But it would address inflation, which is falling short of target, and stay out of the way of bank supervision.