ECB: Large Deposits Do not Imply that LTRO has Failed

• Banks’ deposits at the ECB have increased sharply following the first 36 months LTRO.

• However, it  is wrong to conclude from this that the LTRO has failed to stimulate markets.

The increase in deposits reflects an increase in excess liquidity in just the same way as it did in 2008-10.

Large deposits at the ECB do not imply that LTRO has failed to stimulate government bond market

Some market commentators have argued that the first 36 months long-term refinancing operation (LTRO), in which banks took  EUR490bn in total, has so far not worked as planned because the extra liquidity has simply been placed on the deposit facility at the ECB. However, this argument is false.

The sharp increase in outstanding open market operations (MRO+LTRO) increases excess liquidity (defined as open market operations plus recourse to the marginal lending facility minus autonomous liquidity factors minus reserve requirements) and this excess liquidity shows up as deposits at the ECB in just the same way as it did in 2008-10
.
Does this mean that the operation has failed to stimulate government bond purchases? No, not really. If a bank uses money from the LTRO to buy government bonds (or any other paper) in the secondary market, the amount will still show up as a deposit at the ECB (now on behalf of the seller’s bank). If a bank buys government bonds in the primary market, the amount will also show up as  bank deposits at the ECB if the government spends the receipts or places them at a private bank. Thus, the increase in deposits does not imply that the 36 months LTRO has failed to stimulate government bond purchases
(or other trading for that matter).

Only if the amount received by the government is placed on the government’s account in the central bank will it not show up as bank deposits at the ECB (autonomous liquidity factors would then be increased instead, which happened to some extent in the last few weeks of 2011). So, if governments undertake substantial frontloading of their bond issuances, we should expect to see a decline in deposits.

Also, note that excess liquidity and thus deposits will increase further on 18 January when the reserve ratio requirement is reduced from 2% to 1% as announced after the December ECB Governing Council meeting.