>> GROUP: Shadow ECB Council / EZB-Schattenrat  Andrew Bosomworth

Andrew Bosomworth: Should the ECB introduce another TLTRO and how should it be designed?

The ECB should not introduce another Targeted Longer-Term Refinancing Operation (TLTRO) at this stage, however, it should introduce a new LTRO. The difference between the two operations relates to the subtle difference between funding and liquidity and the modalities of each refinancing operation.

Viewed form the liability side of the balance sheet, funding refers to the act of raising capital to conduct an investment activity. Liquidity refers to funds that can easily be obtained to meet other short-term obligations. Funding is longer-term in nature than liquidity. One of the ECB’s roles is to provide banks with liquidity, which it does via the main refinancing operation (MRO), longer-term refinancing operations (LTRO) and fine-tuning operations. While the ECB’s asset purchase programme and full allotment tender procedures for refinancing operations have structurally changed the quantity and availability of liquidity, there is still a legitimate lender of last resort role for the ECB to provide banks with the opportunity to raise liquidity should they need it.

The ECB should not, however, be in the business of providing banks with term funding. TLTROs provide banks with funding. Ideally, banks should fund themselves in the capital markets and TLTROs should only be activated when the ECB needs to ease its monetary stance. Their long maturity and fixed, subsidized rates make them a powerful tool for the ECB to ease monetary policy. The eurozone arguably does not need additional monetary easing at this stage. The ECB nonetheless needs to find a way to wean banks off TLTRO funding. Not providing an interim facility risks inducing an undesirable tightening of financial conditions.

LTROs provide banks with liquidity. The regulatory landscape for banks has changed, however, since the ECB introduced LTROs with maturities longer than the standard 3-months, and TLTROs, in the wake of the financial crisis. New and pending regulations, like the liquidity coverage ratio and net stable funding ratio (NSFR) among others, are changing the composition of banks’ balance sheets. The combination of these new regulations and the structural increase in excess reserves, most of which the ECB created via quantitative easing, have led to a maturity anti-transformation in which banks are now financing short-term high quality liquid assets with longer-term liabilities.

The ECB should therefore consider the impact of regulation on banks’ balance sheets when calibrating its liquidity-providing facilities. If only to avoid an undesirable tightening of financial conditions, including banks flooding the capital markets with new covered bond and senior issuance, the ECB should introduce a new LTRO to smooth the refinancing of the €734 billion outstanding TLTROs.

The term of the new LTRO should be between 18 to 24 months, so that the funds borrowed are NSFR eligible. The cost should be linked to the ECB’s MRO rate beyond the period of TLTRO maturities, in order to make the additional funds neutral vis-a-vis the existing monetary policy stance. This means funds that banks roll out of existing TLTROs into the new LTRO should continue to attract the existing TLTRO financing rate up until the maturity date of the respective TLTRO. But beyond that the cost should reference the MRO rate.

Should the ECB change its Forward Guidance?

Yes. Eurozone growth has slowed and the FED has signaled a pause in its hiking cycle. The market has responded to these events and pushed the date of the first 15 basis point hike to October 2020. Given the deterioration in the economic outlook, the ECB should validate market pricing and change the time dimension of its forward guidance on interest rates to “at least through the spring of 2020.”

Will the ECB manage to hike rates before the next economic downturn?

Probably not. The window of opportunity for the ECB to raise rates has likely closed now that the FED has signaled a pause. If we define a pause as leaving the policy rate unchanged for at least six months, then when the FED paused in the past, the ECB (and the Bundesbank before it) cut rates in 50% of occasions, left rates unchanged in 32% of occasions and hiked rates during the remaining 18% of the time. The cyclical outlook suggests the ECB should at a minimum remain on pause.

If current uncertainties to global trade abate and domestic demand accelerates, the ECB might be able to raise the deposit facility rate by 15 basis points to -0.25% while the FED is on hold. Arguably, this could even help the profitability of the banking system. And if the world economy improves and growth in America and Emerging Markets does not slowdown in the quarters ahead, which appears unlikely at this juncture, the ECB may even be able to raise rates on all three standing facilities by 25 basis points. Time, however, is working against the ECB’s normalisation ambitions.
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