Wednesday, December 21, 2011

What does record demand for 3 year funds from ECB signify? [update]

The Wall Street Journal reports that 523 Eurozone banks received almost $640 billion in 3 year funds from the ECB.  The question is what does this demand for funds signify.

The stated intent of the ECB in offering these funds was to head off a credit crunch and the resulting recession.

However, this funding operation does nothing to address the cause of the credit crunch.  The cause of the credit crunch is the Eurozone financial regulators requiring the banks to reach a meaningless 9% Tier I capital ratio by June 30, 2012.

Banks have responded to the higher capital requirements by shrinking their asset base as the capital markets are effectively closed to them.  Market participants know that the banks are hiding bad assets.  Market participants also know that they do not have the information they need to be comfortable investing in the banks given what could be hiding on or off their balance sheet.

The situation for Eurozone banks is similar to the situation for Japanese banks for the last 2+ decades and is a direct result of the refusal by regulators to require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Everyone knows that at the time the credit bubble burst these banks had exposure to what would become troubled assets.  However, due to the lack of ultra transparency, market participants cannot see who is holding the losses - look at Spain where the new prime minister suggests there are 175 billion euros of hidden, bad real estate loans.

As a result, private market investors are effectively on a buyers' strike for bank securities.

Even more damaging, by not having transparency into the banks' exposures, the losses on the banks' balance sheet are being effectively transferred to the real economy.  This creates two types of drag on the real economy:  the drag from the losses themselves and the drag from the mis-pricing of assets while the losses are slowly recognized consistent with banks maintaining positive book equity.

This blog has shown historical evidence that investors will buy the securities of banks with negative book equity and that these banks can continue to operate until closed by regulators.  Investors will do so under the condition that the government or Eurozone stands behind the implied 100% deposit and unsecured debt guarantee -- something that occurred at the beginning of the solvency crisis in 2007.

This blog has also shown historical evidence that with ultra transparency the mis-pricing of assets goes away and the economy recovers quickly.

However, what the ECB offered was not ultra transparency, but instead, funds.

My read is that the Eurozone banks took all the funding they could get because of difficulties funding themselves.  The funds will be used to support the assets they will have on their balance sheets when they reach the 9% Tier I capital ratio.


In his Telegraph column, Damian Reece called the ECB funding a lifeline for Europe's zombie banks.

Far from reassuring markets, the scale of Wednesday's bail-out for eurozone banks by Draghi's European Central Bank (ECB) should simply confirm worst fears. 
European banks face a €600bn tsunami of debt coming due in 2012 (mostly in the first quarter) and many simply can't pay up because the usual source of refinancing, wholesale money markets, are refusing to lend them any more. Sound familiar? 
One Northern Rock-style collapse after another would have reverberated around the eurozone over the next three months if the ECB hadn't stepped in with unlimited cash costing 1pc. Almost certainly there would have been a euro-Lehman moment too as a once mighty lender, probably in France, fell over 
Draghi has had to ignore any sense of moral hazard and agree to fund weak banks at the expense of strong. He has opened a quantitative easing (money printing) exercise of enormous proportions. Weak banks unable to fund themselves on the open market are now hooked on cheap ECB money. 
In return they have to post collateral with the ECB, making wholesale money market debt subordinate to the ECB borrowings. These wholesale funds become even more expensive as a result, making it even less likely that eurozone banks can access them in future, thus increasing their addiction to ECB cash. 
Banks accessing cheap ECB funds will lend this on to lowest risk credits, such as blue-chip corporate borrowers, to make an easy profit and rebuild their earnings and invigorate their living dead balance sheets. Bonuses all round....
Nicolas Sarkozy hopes banks will use the ECB's cheap cash to buy sovereign debt from the usual Club Med suspects. But why banks would load up on even more of the loss-making stuff that's caused their capital positions to deteriorate already is unclear. 
There is a carry trade potential of borrowing cheap from the ECB and lending dear to Italy but using three-year money to execute that is against most bankers' instincts and there is a clear risk the trade could go wrong in what are hugely volatile markets. 
Draghi has avoided a devastating 2012 credit crunch but such a cheap, short-term palliative is no cure for Europe's fundamental problems.

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