TLTRO is not a done deal as the ECB needs a monetary policy justification to conduct another round. Such arguments are not straightforward to find. Consequently, we change our call and no longer expect TLTRO to be announced in March. TLTRO will remain in ECB's toolbox, should it be needed.
Banks' credit growth and lending rates do not suggest a broken transmission mechanism, however, a potential fragmentation due to higher cost of funds by particularly Italian banks may be the strongest monetary policy argument there. We do not find the argument strong enough for this to be monetary policy.
Gaining market attention
The discussion of potential additional liquidity measures has received a lot of market attention recently as the maturity of the operations gradually approaches sub 1 year. It is widely viewed that if the ECB doesn’t offer new liquidity operations, it would de facto be tightening monetary policy conditions and given the current economic environment that may not be a warranted. However, after the January ECB meeting we lowered our probability of a TLTRO due to two comments. First, the ECB didn’t task the committees to examine the liquidity situation as widely expected and secondly Draghi stressed that ‘there must be a case of monetary policy for doing it, so it shouldn't be something that we do it as – and they are right – as a sectoral measure, as a country-based measure.’.
We believe that market participants are too complacent by seeing a new TLTRO as a ‘done deal’. In the following we examine the arguments to the extend this is monetary policy and argue that the convincing argument of the need for a euro area wide measure is not there.
Consequently, we change our call and no longer expect a TLTRO now, but it remains available in ECB’s toolbox should it be needed.
Currently, there are still EUR719bn outstanding of the TLTRO, which all mature in March 2021. A Bloomberg survey ahead of the January ECB meeting showed that 89% of respondents expected a new long-term loan (TLTRO or LTRO), with more than 60% of those expecting an announcement at the March meeting.
To fix a specific problem: The history of (T)LTROs
ECB has conducted several Longer Term Refinancing Operations (LTRO) since the start of the global financial crisis. Most prominently, the ECB launched two 3-year V(ery)LTRO in 2011/2012 and a series of 8 T(argeted)-LTROs in 2014 and another 4 TLTRO2s in 2016. Each of the rounds were announced to address a specific monetary policy transmission problem. In 2011/2012 the (V)LTRO were announced in response of liquidity tightening conditions and an interbank lending collapse, while the TLTRO1 (in 2014) was launched in response to a fragmented transmission mechanism in particular in peripheral economies.
In 2016, the TLTRO2 were part of a strong forward guidance package from the ECB.
In the period running up to the TLTRO announcement in June 2014, the lose ECB monetary policy stance was not transmitted to the real economy and credit growth developments were hampered in almost all countries. Countries exhibited contracting loan growth dynamics.
ECB responded to this ‘supply problem’ by launching the TLTRO1 (the ‘stick approach’), whereby banks could get funding at the MRO or up to the lending rate depending on certain lending requirements. The TLTRO2 was part of a strong forward guidance package alongside cut of rates to further foster lending growth at very favourable terms to the real economy, as banks could attain funding at MRO or down to the deposit rate (the ‘carrot approach’). Therefore, in all instances, ECB responded to a specific problem.
Since the launch of TLTROs in 2014, the monetary policy transmission has gradually improved and is now almost fully repaired (in ‘all’ countries), which has been accompanied by spread tightening between banking lending rates to the real economy and the monetary policy rates (deposit rate). Since 2015, the lending rates to the real economy (and in turn the spread to the deposit rate) has been broadly constant.
In short, the (V)LTRO was done to fix a liquidity problem, while the TLTRO were launched to fix a credit transmission problem.
The role of excess liquidity and rates
Excess liquidity is and has been abundant in the euro area since the ECB started its APP in 2015. That is not about to change since the ECB has decided to reinvest the principal maturities in full at least past the first rate hike. We expect reinvestments to take place at least through to the end of 2020. Even if new TLTRO are not offered, and excess liquidity would decline after the EUR719bn of TLTRO matures, we still expect liquidity in the Eurosystem to remain abundant. Since the start of the crisis, the ECB has offered unlimited liquidity as its liquidity operations have been conducted on a fixed rate full allotment scheme. The ECB has said that this continues to be the case at least until the end of 2019. We see this as a formality to be extended. That also means that even if TLTRO were to come to an end, no liquidity cliff effect is warranted and banks can access unlimited funds for a 3 month horizon.
History indicate that the short-end of the money market curve reacts to the amount of excess liquidity once it crosses around EUR300bn (current excess liquidity is EUR1.9trl). At that stage, EONIA drifts lower/higher in the ECB rate corridor between the MRO and the deposit rate. However, that level is likely to be higher this time around, but in our view, even with the ECB potentially not extending the TLTRO, we continue to see EONIA hovering in the lower end of the corridor.
Lending dynamics are strong – except in Italy (and Spain)
Credit growth in the euro area is at its strongest level since 2011 at 2.8% (loans to Nonfinancial corporations), albeit the country level data show a heterogeneous pattern across the euro area. In core euro area, led by Germany and France, annual credit growth were 7.6% and 6.2% respectively for loans to non-financial corporations (NFC). Loans to households are pointing to a similar dynamics for the core euro area. More worrying signs are found in the credit growth developments in Italy and Spain. While Spanish loan growth took a dent in H2 2018, it has been relatively good given the improving banking sector since 2012. However, Italy is more concerning as it has posted contracting loan growth almost continuously since 2012. The TLTRO slowed the banking deleveraging in Italy momentarily, but the negative developments have sped up since the start of 2017 – and further intensified in 2018, amid political uncertainty.
Italian banking sector - findings from the BLS
The ECB published its bank lending survey two weeks ago, and while the overall picture is ok, it does contain a few worrying signs. Most pressing is the tightening credit standards for Italian enterprises and households (for house purchase), as well as tightening cost of funding / balance sheet constraints. However, the TLTRO wouldn’t be able to support the house purchases given the nature of the operation which excludes house purchases in the eligible loan stock. In Q4 2018, credit standards tightened to Italian enterprises due to an increase in the banks’ risk tolerance as well as risk perceptions were no longer an easing factor. Naturally, that is of concern given the high stock of TLTRO funds they have outstanding (EUR239bn), however tightening standards are significantly below the 2011/ 2012 levels. Italy was the only major euro area country that reported tightening standards. Playing the devil’s advocate, one could argue that the drivers of the tightening are selfimposed by lack of a clean-up in the banking sector and domestic policies during the past year, leading to tightening standards for Italian banks. Naturally, the question arises if such a clean-up in the Italian banking sector is a monetary policy case or if this is a banking / fiscal issue.
Politics easy – but then again
At first glance it should be relatively easy to introduce another round of TLTRO as such a monetary policy operation is collateralised, however, as we pointed to above, the ECB deploys monetary policy measures in response to specific problems and currently, there are no imminent problems for the euro area banks. However, without another operation, the ECB would make monetary policy less easy. To balance the argument, ECB president Draghi’s 2017 Sintra speech said that “…a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments – not in order to tighten the policy stance, but to keep it broadly unchanged.” Finally, Reuters reported on Tuesday that there may be some hesitation in the governing council given the change in presidency by the end of October next year and a reduced willingness to commit beyond his term may be warranted.
The prudential ratios argument
A much used argument for another round of TLTRO funding that might be needed sooner rather than later is the requirement for banks to hold enough stable funding to cover the duration of their long-term assets, the Net Stable Funding Requirement (NSFR). In detail, the NSFR is defined as the amount of available stable funding (ASF) to required stable funding (RSF). Assets are assigned RSF factors based on their liquidity and residual maturity, while only funding and capital available for at least one year is qualifies as 100% ASF. As the remaining maturity falls below 12 months, the ASF factor falls to 50% and then further to 0% as only 6 months or less remains.
TLTRO – modalities
As described above liquidity operations have been deployed to address specific problems, and without a clear specific euro area problem, it will be difficult to tailor a response to this (Italian banking fragility should be addressed via other means, such as the ESM bank recapitalisation). However, should it come, we do expect it to be a much watered down version of the current ones. In such a case, we could envisage that it would be an indexed rate with a sub 3y horizon at the MRO or up to lending rate, in order for this not to make it too attractive a carry trade for banks. The ECB shouldn’t want this measure to be seen as increasing profitability of the banks. Furthermore, given the SSM mandate within ECB, the ECB’s wish to have banks ‘stand at their own feet’ should prevail.
Conclusion
In sum, we do not see the very strong argument of another TLTRO round at this stage as the transmission mechanism is functioning and abundant liquidity is present in the market. However, we acknowledge the risk of the ECB announcing this due to the ‘Draghi put’ and without announcement it would be de facto tightening, which may not be warranted at this stage. However, with the NSFR date postponed, there should be no urgency to announce this measure. We therefore assign 75% probability of TLTRO not coming at this stage. It will remain in the ECB’s toolbox and can be used at later stage should it be needed.