What is the ECB endgame?

Everyone is happy that bond yields are falling, but what is the next step in the resolution of the crisis?  Here is one report from the front, decide for yourself whether it is good or bad news:

Last week 800 banks requested €529.5bn of three-year funding under the European Central Bank’s longer-term refinancing operation, on top of €489bn borrowed in the first tranche of the LTRO in December.

The €1.019tn total is not far shy of the €1.106tn of European bank senior debt due to mature in 2012, 2013 and 2014 combined, according to Goldman Sachs, which said the “extremely high” injection of capital means “European banks are now effectively pre-funded through to 2014”.

Given that the ECB funding costs 1 per cent, compared to yields on senior debt of 3.5 per cent, some believe many banks will simply let much of their senior debt mature…

It would be an exaggeration to claim that the ECB has taken over European capital markets for three years, but you can see where my thoughts are headed.  What happens when the three years is up, or as that time approaches?  I see a few possible scenarios:

1. Banks recapitalize themselves with sound lending, and at the end of the three years they return to private capital markets by issuing debt.  What would the new cost of capital be?

2. European banks continue to hover on the precipice for three years, and as expiration approaches the ECB renews its commitment to fund.  (If the ECB funds the banks for six years running, at what point are the banks de facto nationalized?  After how many years of ECB funding at one percent is it impossible to return to private markets?)

3. As expiration approaches, no one will be quite sure whether European banks still hover on the precipice, and so the ECB will implicitly signal a willingness to run another three years credit if the private money is not there.  That will make the banks less interested in cleaning up and raising the private money.  How are banks encouraged to reveal the true state of their market?

4. By the time the three years is up, a lot of these institutions will have been nationalized, if only de facto.

The Eurozone is now in a recession, with further financial shocks likely to come (more Greek problems, Portugal falling into receivership, Irish referendum, French election, slowdown in China, etc.)  What is the probability that #1 comes to pass? I say below fifty percent.  Just how bad is #2-3?  What other options are there?  How long would it take for de facto bank nationalization to lower the economic growth rate?  How long would it take before re-privatization is an option?

By the way people, we’re exploring the best case options here, they did avert disaster in December!  For now.

Addendum: Gavyn Davies expresses further reservations.  And Karl Smith comments.


They are nationalizing in more way than one: banks are dumping foreign sovereign debt and buying domestic debt. The nationalist political parties will be even more powerful in three years and the countries will be in a better position to act in their self-interest.

I take it as a positive sign that we've moved on from "What are they going to do next week?" to "What are they going to do in three years?"

The doomsday pundits seem to have eased up a bit.

They always find something else to harp on

In this game there is one result... the central banks /being/ the capital markets.

I doubt any player in an open ended game has anything you could reasonably call "endgame", but if we're talking "goals" I'd say the obvious answer for ECB, EU et al. is "to grow" and they seem to be doing just fine. This so called crisis will go into perma-mode just like, say, the Israeli–Palestinian conflict and will be providing work for the "international community" for decades to come.
Oh, and when you start talking about "de facto" it may be a good start to recognize that in any fiat currency with a lender of last resort banks are nationalized in all but name anyway. And speaking of sovereignty, it might be noteworthy that Greece has not been sovereign since the 15th century. So we are only talking about which foreign entity is calling the shots there and the benevolent "international community" at least pays good money for that privilege.

Gavyn Davies: "It is now widely recognised that a central bank cannot become insolvent in the same way that a private company can."

I recently had the chance to ask an ECB's market operations staff member (a German) about the ECB's view regarding whether the ECB would ever need to be recapitalized in the event of losses in excess of the ECB's thin layer of capital. He dithered a bit on this point as there is some debate inside the ECB on this question. Some take the view that a central bank that shows negative equity a) loses credibility and b) invites a greater chance of inflation, and that therefore the national central banks would in fact need to recapitalize the ECB.

However, he also pointed out (correctly) that fiat central banks do not need to maintain positive equity. Also, central banks can get creative with their accounting to eliminate negative equity. For example, a central bank could simply add the present value all future senioriage into perpetuity to its balance sheet to make its ledger positive. Central bank accounting rules are typically set by legislatures, and legislatures may not want to spend scarce tax dollars on recapitalizing the central bank.

After a certain point they lose control of the de-facto currency in their own country, as people switch en-mass to a different currency and then they die.

I mean the central banks die, not the people.

>> How long would it take for de facto bank nationalization to lower the economic growth rate?>>

What do you mean by de facto nationalization? The ECB is not taking equity. Is it asking for debt covenants that give it control? Don't regulators already exercise substantial control over banks, which rely on government for their existence (deposit insurance, etc.)?

Why would nationalization lower growth? If present management is so incompetent as to require ECB support to survive, if not have triggered financial crises, why would replacing them hurt?

I'm beginning to wonder whether their intention was just to get us through the winter. Power supply failures and the like are less lethal in Spring or Summer.

I think that these are politicians flailing, I think they are too far down this road to even think of an endgame, because they are actually pretty smart and every imaginable endgame is a complete disaster.

I'm not even blaming them for this, you know the old story about the guy who is about to be executed, the king asks him if he has anything to say for himself and he says: "Give me a year, and I'll make your horse talk," the king laughs and agrees but says if the horse isn't talking he will be put to death. Afterward, he jailer says "What were you thinking? You'll never teach that horse to talk." The condemned man's reply: "A year is a long time, a lot can happen in a year. I could die, the king could die, the horse could talk.

"Everyone is happy that bond yields are falling...."? Really? Maybe I like bonds with high yields.

This is a joke right? If you're serious you are already loaded with higher yielding Eurodebt and have a huge cap gain on it now plus are still getting the high yield on your initial investment.

He might also be looking to invest money into bonds, in which case a higher yield is more attractive, assuming that the risk profile is, in essence, unchanged.

Bond yields affect broader interest rates. If you're living on an annuity, have a money market account, or simply have a lot of money in the bank, falling bond yields are most certainly *not* good news.

Isn't this just what happened in the US? Except the Europeans did it in a way that was (more) palatable to the German elites. Banks are not nationalized in the US, and we're still worrying about if the Fed will ever be able to go away from the de minimis interest rate policy.

Idk that one can call that nationalization, even in a de facto sense. In some ways it's the opposite, The governmental arm isn't extracting any of the benefits of owning equity; rather it's just subsidizing the banks' carry of their assets for the benefit of private owners, who are immnized from the collapse of value of assets that would otherwise occur.

A: Get while the gettin's good...

Comments for this post are closed