The ECB’s two souls

Over the past few weeks, speculation has been rife that the ECB may well be poised to launch a fresh liquidity injection for European banks. In principle, new long-term tenders would enable the monetary custodians to ensure that financing conditions remain favourable even after the current TLTRO-II operations have matured. What is noteworthy is that this particular topic is already being keenly debated; after all, the first TLTRO-II tender will only be falling due in June 2020.

This sense of temporal urgency is a result of regulatory requirements for banking institutions. If the residual maturity of cash flows falls below a one-year horizon, they no longer count when certain parameters (net stable funding ratio / liquidity coverage ratio) are computed. Against this backdrop, banks from the European periphery in particular – especially Italian and Spanish banking institutions – could be compelled to shrink their balance sheets in order to comply with the respective statutory ratios. A possible undesirable knock-on effect of this would be more limited, and more expensive, bank lending. In addition, it could be conceivable that banks would reduce their government-bond holdings, which might possibly entail higher risk premiums. In recent years, Italian banking institutions, in particular, have purchased a substantial volume of domestic sovereign securities in order to set up carry trades. We consider a fresh injection of liquidity from the ECB, as a measure aimed at counteracting a widening of risk premiums, to be distinctly probable. However, the monetary authorities would probably wish, at the same time, to avoid making the impression of only rushing to the aid of banks and government-bond markets in the periphery of the eurozone when launching fresh long-term tenders. The ECB’s top echelons would therefore be likely to mainly accentuate that bank lending was slowing in Southern Europe when communicating such a step. On the other hand, that shows the conflict of interest in which the ECB finds itself on account of its dual role as banking supervisor and monetary custodian.

We think that there is a distinct likelihood of the ECB deciding on fresh liquidity operations at the next Governing Council meeting, scheduled for 7th March. The expected downward revision in the ECB staff’s economic-growth and inflation projections ought to make it easier for them to justify the need for further liquidity measures. However, the interest-rate bonus linked to lending could turn out to be less generous than in the terms of the current TLTRO-II operations in order to signal the ECB’s ongoing determination to return to monetary-policy normality but also to resolve the bank’s conflict between its two roles. But one rather interesting question remains: whether fresh targeted longer-term refinancing operations would merely delay the ECB’s endeavours to normalise its monetary policy – or whether such endeavours have, in fact, already ended in complete failure.

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