Three-year LTROs successful against lending drought

The special operations, carried out on 21 December and on 29 February, enjoyed broad demand from institutions in the euro area. Not only was total participation very high, at over EUR 1,000 billion, the number of participating banks was also much higher than usual, in particular in the second operation, with 800 banks participating.
The operations aim to avoid a decline of bank lending in the euro area. Their effectiveness depends not so much on their size as on the attractive conditions applied by the Eurosystem: a very long maturity of three years combined with low pricing. These favourable conditions, plus the dire straits in which many European banks currently find themselves, explain why the demand for liquidity in these operations was  much higher  than the amount the European banks really need:

• Usually, European banks provide for adequate distribution of the available liquidity through short-term lending and borrowing on the interbank money market, where the liquidity surplus of one bank makes up for the shortage of another. Owing to the crisis, however, the interbank money market has been disrupted for several years. Banks are reluctant to lend liquidities, especially to peer institutions with a lower perceived creditworthiness
• At the same time, many banks have difficulty in obtaining longer-term funding. Over the next few years, large amounts of longer-term debt will mature, and banks will have to either roll over these debts or redeem the principal. A bank that is unsure about whether it will be able to renew its debts will be reluctant to extend loans to clients, because it may need the money to repay its own creditors. Thanks to the longer-term loans from the Eurosystem, banks are able to support their lending business and at the same time create a buffer in case they need to redeem loans they are unable to roll over. Thus the European banking industry is given the breath of air it needs to carry out necessary balance sheet reforms in an orderly fashion without putting an unnecessary drain on lending. Eventually, the reforms should enable banks to redeem their loans from the Eurosystem.
• The favourable price-setting provides an additional  incentive to banks to support their lending activities. By on-lending the liquidities from the LTROs to their clients at higher rates, banks may make an additional profit, which also helps to strengthen their financial buffers.

 

The high participation rates in the two special LTROs brought far-reaching changes in the balance sheet of the Eurosystem. Figure 1 presents the development of the liquidity situation in the Eurosystem, and shows how the special measures led to a strong increase in the recourse banks had to the Eurosystem deposit facility. The deposit facility allows banks to ‘park’ surplus liquidity with the central bank at an interest rate of, currently, 0.25% per annum. Between 2 December 2011 and 2 March 2012, both lending by the Eurosystem and deposits in the deposit facility increased by just under EUR 500 billion.

This does not mean that the operations have not helped to support bank lending. The increase in recourse to the deposit facility is a logical consequence of the LTROs. Under normal conditions, the Eurosystem narrowly aligns its liquidity supply with the total liquidity needs of the banks. If the supply of loans is equal to the banks’ liquidity needs, recourse to the deposit facility will be zero. In response to demand from individual banks, however, the Eurosystem currently extends more loans than the euro area banks really need, thereby creating a liquidity surplus. During the day, the surplus liquidities are moved between the accounts banks hold with their central banks. At the end of each day, the surplus is moved to the deposit facility by the banks that currently hold it.

 

This happens independently of developments in bank lending, as may be illustrated by an example. Suppose a bank uses the loans obtained from the Eurosystem to supply additional credit to its clients. Initially, this means the bank will increase the balance on the account of the borrowing clients. While the clients leave their bank accounts untouched, the bank’s balance on its central bank account remains unchanged. Now, suppose the client makes a payment to a party that holds an account with another bank: this time, the lender bank must actually transfer funds to its fellow bank to settle the payment of its client. It will do so by transferring cash from its own central bank account to the central bank account of its fellow bank. The total amount of money in the accounts held with the central bank still does not change. In a liquidity surplus situation, the settlement of all payment flows will leave some banks holding extra money at the end of the day. These banks have two options open to them: they may leave the money in their payment account with the central bank or they may have recourse to the deposit facility. Since the Eurosystem pays no interest on account balances held by banks in excess of their so-called minimum reserve requirements, the deposit facility is the most attractive place to leave surpluses, so this is where the surplus liquidity will end up.