Tuesday, January 31, 2012

ECB life-line necessary because no one knows which EU banks are solvent

I am surprised by much that has been written about the ECB life-line, otherwise known as the long term refinancing operation or LTRO, that shows a lack of understanding of this life-line.

LTRO was implemented for a very simple reason:  no market participant can figure out which of the EU banks are solvent and which are not.  Included in the market participants who cannot answer this question are banks and private sector investors.

LTRO was necessary because without it the EU banking system was going to implode due to a lack of liquidity as market participants wanted to be repaid on their existing exposures and were unwilling to rollover into new exposures.  As this blog has documented and the ECB's Mario Draghi confirmed, both interbank lending and unsecured bank debt markets are frozen.

LTRO is all about substituting funds from the ECB for funds from the credit markets.

Since it is all about substitution of one funding source for another funding source, we are talking about a program that effects the right hand side of the bank balance sheet and not the left.  LTRO is not about stimulating loan growth or sovereign debt purchases.  It is about fund the loans and sovereign debt that already exist on the balance sheet.

The primary driver for lending and sovereign debt purchases is compliance with the 9% Tier I capital ratio requirement.  As predicted on this blog, this compliance is causing a credit crunch in the EU as banks shrink their balance sheets.

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