Draghi's free lunch boosts Eurozone bank profits

A Bloomberg article looked at the difference between what the ECB is charging Eurozone banks for access to its long term repurchase operation and the average cost of unsecured bank debt and concluded it is a substantial bailout.

While the Bloomberg analysis compares apples (the ECB program is 'secured' lending) versus oranges (the unsecured bank debt market is frozen), it does highlight that ECB funding is replacing funding from the unsecured debt market.

The article also highlights the simple fact that bailouts based on subsidizing a bank's net interest income are an inefficient method of increasing bank capital as bankers pay themselves bonuses from the earnings.

Banks are benefiting from a European Central Bank subsidy that could reach 120 billion euros ($158 billion), enough to pay every bonus at financial firms in London for the next 24 years at today’s levels. 

Royal Bank of Scotland Group Plc, BNP Paribas SA (BNP) and Societe Generale SA are among more than 500 banks that took 489 billion euros of three-year loans from the Frankfurt-based ECB at a December auction. 

The loans currently carry a 1 percent annual interest rate, less than a quarter of the 4.3 percent average yield on euro-denominated senior unsecured bank debt of all maturities in the past year, according to Commerzbank AG. 

With borrowing estimated to hit a record 1.2 trillion euros after a second auction later this month, banks may save 120 billion euros over three years. That could boost 2012 profit by about 10 percent for lenders in Italy and Spain, according to estimates by Morgan Stanley. 

“This is very much a free lunch,” said Arnd Schaefer, an economist at WestLB AG in Dusseldorf, Germany. “Banks can get money for just 1 percent and then lend it on for much more. That’s pretty good.” 

The ECB is flooding the banking system with cheap money in a bid to avert a credit crunch after the market for unsecured bank debt seized up last year and funding from U.S. money markets disappeared. Any bank in the region can borrow an unlimited amount, provided it pledges eligible collateral. Lenders won’t face curbs on bonuses or dividends.

I would guess the ECB does not place a curb on bonuses or dividends because it is trying to encourage the banks to borrow and a curb would act as a disincentive.

This highlights one of the problems with the Japanese model of pretending insolvent banks are solvent.  Bankers are entitled to cash bonuses from insolvent banks.

Under the Swedish model, the banks would have recognized their losses and would have a large negative book capital.  While the banks capital was below regulatory minimums, bankers don't receive cash bonuses.

“The central bank has pumped the market with unbelievably cheap money because wholesale markets are closed,” said Richard Reid, director of research at lobby group International Centre for Financial Regulation in London and a former managing director at Citigroup Inc. “Stronger banks will inevitably profit, but that is a secondary issue for the ECB.”... 

Banks are required under rules approved by the Basel Committee on Banking Supervision to hold capital against any assets they pledge as collateral in exchange for the ECB loans, pushing the cost of participating above 1 percent, Guy Mandy, a London-based Nomura Holdings Inc. analyst, said in a Jan. 24 note. 

Assets are subject to so-called haircuts depending on how risky they’re perceived to be. That affects how much cash lenders will receive against the value of the assets.

A bank that pledges a book of loans with a five-year maturity subject to a 29 percent reduction in value would face an “all-in” cost of about 2.5 percent a year, Mandy said....

I don't know how he is doing his calculation, but haircuts on assets that are pledged (versus "sold") don't raise the cost of participating.  A security held in the bank's vault or at the ECB yields the same to the bank.

“You are certainly going to get banks that don’t need the funds profiting,” said Richard Werner, an economist at the University of Southampton, England. “It would be much cheaper to target support for the 20 or so banks that need it, but politically the central bank wants to be seen to be neutral. It is a massive money-making opportunity for those who don’t need it to play the yield curve.”...

Some banks, rather than heed calls by politicians to boost lending to companies and consumers, are choosing to deposit the money in the ECB’s overnight facility at a rate of 0.25 percent until they need it to refinance maturing debt. While that’s costing them 0.75 percent, it’s still a saving on the potential expense of issuing bonds to private investors....

As this blog has repeatedly said, market participants cannot determine which banks are solvent and which are insolvent and as a result are not interested in lending or investing to any of them.

Just 4 percent of investors polled by Goldman Sachs said they thought the proceeds would be used to increase lending to customers, compared with 56 percent who said it would be used to refinance maturing debt and 26 percent who said it would be invested in sovereign bonds....

Banks also are cutting lending outside their home markets, data compiled by the Bank for International Settlements show. Euro-area banks reduced lending to Asia by 9 percent and to central and Eastern Europe by 8 percent in the third quarter....

This is a result of the financial regulators' 9% Tier I capital target.

A target that is not restoring confidence in banks, but is certainly precipitating a credit crunch.

Of course, the ECB program is helpful in generating earnings to that the banks can reach that target.

The ECB is encouraging all banks to participate in the second auction. 

“There is no stigma whatsoever on these facilities,” ECB President Mario Draghi said in Frankfurt on Feb. 9. “The use of these proceeds is a business decision. Our primary interest is in lending to the real economy.”

However, the money won't make it to the real economy because banks are cutting back on lending so as to achieve the 9% Tier I capital ratio.  Goldman's investor poll appears to confirm this.