What is the difference between LOLR to banks and LOLR to governments?

Draghi says yes to loans to banks, for a three-year period and with weak collateral, and no to loans to sovereigns, in accord with current EU law.  (Admittedly his remarks require further parsing and so this interpretation is subject to revision.)  What does the Modigliani-Miller theorem say?

A cash-strapped government will start a bank.  A cash-strapped government will induce a domestic bank to lend more to it.  A cash-strapped government will force a domestic bank to lend more to it.  Remember the era of “financial repression”?

To some extent governments will internalize the value of this guarantee to banks.  If you don’t think this guarantee to banks somehow transfers to governments, won’t ECB-guaranteed claims on the bank become the new safe domestic security, knocking out the market for the riskier sovereign stuff and thus mandating some kind of risk equalization to keep the whole show up and running?

Is this transfer of the subsidy to the sovereign a bug or a feature of the plan?  Perhaps this is how the EU/ECB, viewed for a moment as a consolidated entity, will circumvent EU law to finance troubled governments.  Is it possible that by changing collateral requirements they can alter the flow of funds to governments in a discretionary, ever-changing, and relatively non-politicized fashion?  Does this satisfy the “too complicated for people to complain about” provision?

Three years.  Given recent events, that feels like a very long time horizon.  So as long as the available supply of collateral allows, banks would seem not so unwilling to advance funds to their governments, directly or indirectly, and that’s assuming they have a choice in the matter.  The new game will be to generate lots of usable collateral, because the overall credit demands are going to be very high.

Will the “not very tough cops,” namely the ECB-backstopped domestic banks, help the national governments avoid reforms and avoid IMF-enforced toughness?

What does the endgame look like when the three years is up?

All of this is subject to revision, but it is my preliminary take on what happened today.  The market doesn’t seem to have liked the announcement.  Here are other reactions.

I thank Garett Jones for a useful conversation related to this post.

Comments

Here's my proposal: whatever lending opportunities you grant to European banks or sovereigns, you have to also allow to individuals.

0% interest borrowing for 3 years on zero or weak collateral? Then you have to let Friedrich refinance his business on those terms too.

Borrowing from domestic banks would be contrary to the austerity measures adopted by much of the Euro zone.

If the ECB wants to finance governments, it can buy bonds in the market. No need for this provision "to circumvent EU law."

>>Does this satisfy the “too complicated for people to complain about” provision?>>

Whatever happened to rational expectations and other macro theories that said you can't fool people or the market?

At some point, governments may notice that we need more growth and that austerity won't help. The market is disappointed because today's announcement seems another denial of that reality.

Gov't can seize the LOLRUS's bucket, whereas banks would have to buy it, or at least distract him with some fish.

Isn't it a question of what works? A LOLR has to be seen as a LOLR.

Shouldn't it be really simple for Greece to game the Euro fractional reserve banking system to fund all the debt they want to issue?

(1) Take over the biggest bank in Greece and install your cronies (if this step hasn't already been done)
(2) Have the bank purchase 100 M Euros of newly issue Greek bonds from the government
(3) The Greek government uses 10% (or whatever the capital ratio required is) of the money to buy newly issued bank stock
(4) The bank uses part of the 10% (2.5% or whatever the fractional reserve ratio is) to buy German government bonds on the open market and deposits them with the ECB which increases the banks reserves and authorizes it to create more Euro deposits.
(5) Repeat steps 2 to 4 increasing the amount without limit

What prevents the ECB from suspending lending to such an obviously rogue bank?

Rogue in what way? It exceeds the capital requirements and is depositing top-quality securities as it's reserves. I don't think the ECB has absolute discretion to pick and choose member banks.

Other investors do have discretion. As a result the bank is likely to have trouble obtaining other funding besides ECB. Its share price and other market indicators will reflect the scam. It will then become a creature of the night, entirely dependent on the ECB transfusions -- and a lightning rod for public discussion across Europe.

p.s. Great scheme all the same.

"Is this transfer of the subsidy to the sovereign a bug or a feature of the plan? Perhaps this is how the EU/ECB, viewed for a moment as a consolidated entity, will circumvent EU law to finance troubled governments. Is it possible that by changing collateral requirements they can alter the flow of funds to governments in a discretionary, ever-changing, and relatively non-politicized fashion? Does this satisfy the “too complicated for people to complain about” provision?"

Good post. It is probably a feature, not a bug, and it is surely "too complicated for people to complain about," at least for now.

This isn't a new thing, though. The ECB has been lightening up collateral requirements for a few years now, presumably in part to finance weak governments through the back door. Remember when the ECB broke its rules and began accepting BBBminus-rated collateral?

The only reason I don't completely "buy-in" to what you are saying in this article is that the European Banking Authority is saying that the banks aren't capitalized well enough so the potential to lever up isn't obvious to me.

Perhaps the EBA will allow they more leverage with Italian bonds? Perhaps but I'm not aware of this being done.

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