Subsidized Haircuts in Eurosystem Refinancing

In his November 26 speech to the Hyman P. Minsky Conference in Berlin, ECB Executive Board Member Peter Praet said that the Eurosystem's collateral framework lets the private market decide which assets to post as collateral.  In contrast with the Fed's asset purchases, he argues, Eurosystem refinancing operations do not favor certain assets over others.

Asset purchases directly create scarcity in the instrument being purchased. This exerts an upward pressure on prices, and, through portfolio rebalancing effects, may also affect the prices of other assets. However, direct asset purchases involve a difficult choice for the central bank: it must take a decision on which assets to buy, necessarily interfering with relative asset prices and income distribution.

Collateralised lending involves such decision only at the level of the definition of the collateral and its eligibility conditions. This can also influence the prices of collateral, but the role of selecting which assets to buy or sell is essentially “outsourced” to the banking system, that is, to many private agents. Hence, collateralised lending leaves the price discovery process and the allocation of savings to market mechanisms.

Praet's description minimizes the Eurosystem's role in favoring certain assets over others.   The Eurosystem expresses a variety of preferences in the selection process for collateral.  Many of these preferences, expressed by the size of haircuts, may be similar to the private market.  But as the Euro area has seen increased volatility in its sovereign debt markets a haircut gap with the private market have emerged.

As an example, Spanish 2 year debt is haircut 3.5% at LCH and only 1.5% at Eurosystem operations.  Spanish 8 year debt is haircut 10.25% at LCH and only 4% by the Eurosystem.  If the LCH is any proxy for the rest of the private market it is not difficult to understand why Spanish banks have done more of their refinancing at the Bank of Spain as volatility (and thus private market haircuts) in Spanish sovereign debt began to rise late last year.  The subsidy, in comparison with the private market, is evidence that the Eurosystem does not "essentially 'outsource'" decisions on asset purchases.

Haircuts in eurosystem refinancing operations

LCH Haircuts as of 11/30/2012

Link - debt default as solution to euro crisis

A good analysis from last Wednesday's Irish Times by Ashoka Mody of Princeton

European Officials as the Source of Convertibility Risk

ECB President Mario Draghi identified convertibility risk as the source of increasing yields in Spain and noted the ECB's mandate and determination to address it since there should be no convertibility risk in the euro.  Under the relevant treaties, membership in the EMU ranges from "irrevocable" to "irreversible".    Nevertheless, the risk of a euro exit by Spain concerned depositors and investors in Spain.  What explains this?

In early May, there was a spate of remarks by European officials that could have affected perceptions of the irrevocability of the euro:

• On May 8, in the wake of the first round of Greek elections, ECB Governing Council member Jorg Asmussen threatened: "Greece needs to be aware that there are no alternatives to the agreed bailout program, if it wants to stay in the euro zone."
• On May 10, similar comments followed from European Council President Van Rompuy and European Commission President Barroso (EU Turns the Screw on Athens...).  
• On May 11, in response to a question of whether Greece could be forced from the EMU, Barroso amplified: "Look, if a member of a club, I don't want to talk about a particular country, but if a member of a club does not respect the rules, it's better that it leaves the club...."
• At the May 14 Eurogroup meeting, Eurogroup head Jean-Claude Juncker warned his colleague Greek Finance Minister Filippos Sachinidis: "If we now held a secret vote about Greece staying in the euro zone…there would be an overwhelming majority against it."

That these comments came from European officials was surprising, as they are creatures of the collection of treaties that make the euro irrevocable.

A measure of the interest of Spaniards in this topic is the frequency of searches from Spain in Google for "exit from the euro" without mentioning Greece and "open an account in Switzerland".  (We recognize that the share of population that does these searches is small.)  This graph overlays these measures on a chart of the 2-year yield spread between Spain and Germany:

People had discussed Greece's departure before Asmussen’s speech, but the idea that the ECB and EU officials could cause it was new.  Depositors and investors in Spain, already concerned by bank solvency, may have thought that this casual treatment of euro membership could apply to Spain as well.

Draghi attempted to repair the damage  on May 16:

"While the ECB will continue to comply with the mandate of keeping price stability over the medium term in line with treaty provisions and preserving the integrity of our balance sheet, I want to state that our strong preference is that Greece will continue to stay in the euro area."

This failed to stop the rise in Spanish yields.   ECB changed "strong preference" to "immutable preference" two days later, with little effect.  It's difficult to counter effectively what appeared to be the broad-based view of EU officials.

A further round of stress in Spain began during the week of July 16, when news that the Troika would be inflexible in its upcoming visit to Greece reignited concern over Greece's ejection.  This began with a leak of a draft Troika report describing the "awful" situation in Greece. Reports of the Troika's inflexibility grew during the week.  This culminated over the weekend of July 21 when three senior German government ministers said there would be no flexibility and suggested that Greece should leave the euro.

On July 26, Mario Draghi indicated that the ECB would "do what it takes", which became the OMT program to buy bonds of countries with convertibility risk premia.  Draghi's dramatic move was intended to respond to a crisis perhaps triggered by his own contemporaries.

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Preview of Forthcoming Post: 
Convertibility risk isn't the only cost of a Greek departure.  Presumably unconsidered by the officials who spoke of Greece's departure was the effect on the ECB's balance sheet.  Given the ECB's exposure to Greece through Target2 of about €120bn, a loss of that would have left the ECB with negative equity of about €-100bn, not counting any SMP losses.  (The ECB's exposure to Greece is not collateralized.)  Since the provisions of the treaty ( PSESCBECB Articles 10.3, 28.1, 32.4, 33.2, and Council Regulation 1009/2000) require a  weighted 2/3 vote to go beyond modest recapitalization or loss sharing in the event of a large ECB loss, the ECB could be stuck with negative capital.  This would be awkward at best. 

Convertibility Risk - Cherry Picking* Interest Rate Spreads

ECB President Mario Draghi explained that the OMT program to buy sovereign bonds was within the ECB's mandate because unfounded fears of a euro exit had caused excessively high yields in Spain and Italy. Speech to the Bundesverband der Deutschen Industrie, September 25, Berlin:

"In recent months, we have seen highly divergent borrowing costs for the real economy in different parts of the euro area. In our analysis, these differences were larger than justified by individual credit risk. They reflected, to a considerable extent, unfounded fears about the future of the euro area.

For example, a loan to a family in Germany for a house purchase with a five- to-ten-year maturity had an interest rate of 3%; the rate for a comparable borrower in Spain was 7.5%. At the same time, the average firm in Germany paid around 3% for a new loan over five years, while the average firm in Italy paid above 5.5%.

In these circumstances, monetary policy cannot work properly. This is because a key channel through which the ECB ensures price stability is through the cost of credit, in particular bank credit. Bank credit accounts for about 70% of external financing of euro area firms, and that ratio is even higher for smaller enterprises.

But if we are unable to influence borrowing costs in some parts of the euro area, this channel is disrupted. Firms and households have less access to financing, economic growth stalls and these regions are faced with a risk of deflation. In other words, our ability to ensure price stability for the whole euro area is compromised.

The ECB’s Governing Council therefore faced a choice: to accept this situation and allow the singleness of its monetary policy to be undermined; or to take actions within its mandate to restore the normal transmission of monetary policy across all parts of the euro area. We decided in favour of the latter."

Mortgage Rates in Spain

"For example, a loan to a family in Germany for a house purchase with a five- to-ten-year maturity had an interest rate of 3%; the rate for a comparable borrower in Spain was 7.5%." 

The ECB picks the red line to demonstrate the presence of convertibility risk:

(Source: ECB Statistical Warehouse. Spain: Up to 1 year, Over 1 and up to 5 years, Over 5 and up to 10 years, Over 10 years; Germany: Up to 1 year, Over 1 and up to 5 years, Over 5 and up to 10 years, Over 10 years)

The ECB chose a persistent outlier to make this point. Both longer and shorter maturities had much lower rate differences than did their category.

Strikingly, the chosen maturity category has de minimis volume in Spain:

(Source: Banco de Espana)

The fact that most new Spanish mortgages appear to have maturities of up to one year should not surprise us. As the European Mortgage Federation observes, the vast majority of outstanding mortgages have rates that float to Euribor. The Banco de Espana notes, "a 15-year loan at an annually revisable rate is classified under the term 'Up to one year'." 

While the difference between five-to-ten year Spanish and German mortgage rates in July was 4.5%, it was between 0% and 1% for the categories with reasonable volume in Spain.  We can fit both convertibility risk and "individual credit risk" into a 4.5% spread, but less easily into a 1% spread.

Corporate Loan Rates in Italy

"The average firm in Germany paid around 3% for a new loan over five years, while the average firm in Italy paid above 5.5%"

To demonstrate the existence of a convertibility risk premium, the ECB again picks the widest spread. 

(Source: ECB Statistical Warehouse. Italy: Up to 1 year, Over 1 and up to 5 years, Over 5 years; Germany: Up to 1 year, Over 1 and up to 5 years, Over 5 years)

Though the chosen series has meaningful volume, the over five-year spread, 2.5%, is twice as large as the up to one-year spread. 

The ECB has pointed to Spanish mortgages and Italian corporate loans as cases of a convertibility premium. Such a premium should manifest in all Spanish rates, including corporate loans.  

We present the spreads of corporate loans in Spain over Germany, which the ECB did not discuss. Notice that there are no outlying series. 

(Source: ECB Statistical Warehouse. Spain: Up to 1 year, Over 1 and up to 5 years, Over 5 years; Germany: Up to 1 year, Over 1 and up to 5 years, Over 5 years)

Now let us compare the spreads of both countries to Germany:

(Source: ECB Statistical Warehouse. Spain: Total maturity, total amount; Italy: Total maturity, total amount; Germany: Total maturity, total amount)

The ECB's choice of the 2.5% spread in Italian over five-year loans looks even more like cherry picking when one sees that the weighted average rate spread of new loans is around 1%, and has been all year. 

The data starting in the fall of 2008 show that Spanish and Italian borrowing costs declined vis-a-vis Germany through 2009, and did not start rising from negative levels until spring, 2010. The period of negative spreads in 2009-10 might make one question the ECB's numbers, or recall how German landesbanken had an unsolved problem of toxic assets and a shortage of equity capital, while Spanish authorities were the paragon of thoughtful banking regulation. 

Note the recent spread levels: Italian banks have loaned euros to corporations at 100 basis points over Germany rates since December, 2011. And while Spanish corporations saw their rates rise as high as 125 basis points over German corporations in May, the first quarter was lower, and rates did not persist at that high point. Indeed, the same problem from the mortgage example applies here: a 100 basis point spread is simply not wide enough to capture both convertibility risk and "individual credit risk". 

Thus these comments should not be taken as skepticism of a convertibility premium in these rates**. However, we do not think the data presented justify such a finding. 

* Probably unintentional. Cf. confirmation bias.

**There are aspects of the data that we do not understand. For example, initially floating-rate mortgages of all maturities are categorized as 'up to 1 year' mortgages. We do not yet know the maturities or structures of such loans, and how they can be compared across countries. This is also true for corporates. 

Spanish Deposits

A chart from the Bank of Spain showing average rates paid on new deposits by banks in Spain through August 2012 (term and overnight).  Do these rates evince a banking system desperately trying to hold onto fleeing deposits?

Loss Sharing in the Eurosystem

Our Claim: 

Monetary policy operations are only shared pursuant to a capital key weighted majority vote.  

Loss Sharing between NCB’s: 

Article 32.4 of the ESCB Statute:

The amount of each national central bank's monetary income shall be reduced by an amount equivalent to any interest paid by that central bank on its deposit liabilities to credit institutions in accordance with Article 19.

The Governing Council may decide that national central banks shall be indemnified against costs incurred in connection with the issue of banknotes or in exceptional circumstances for specific losses arising from monetary policy operations undertaken for the ESCB. Indemnification shall be in a form deemed appropriate in the judgment of the Governing Council; these amounts may be offset against the national central banks' monetary income.

                                      

What experts say:

Karl Whelan:

“The official legal statute governing the Eurosystem is quite vague about the implications for an NCB of losses incurred in monetary operations… In practice, the Governing Council of the ECB used the defaults by Lehmans sic and other banks in 2008 to clarify in a statement in March 2009 that losses should be shared in full by the Eurosystem NCBs in proportion to their ECB capital key shares.” 

Willem Buiter:

“Losses and profits made by the ECB and the NCBs in the implementation of the common MCL policy are shared among the NCBs in proportion to their share in the ECB capital.” 

JP Morgan:

“The losses incurred by the Eurosystem are to be shared by all national central banks in proportion to their shares in the ECB's capital.” 

Our interpretation:

Based on the Protocol on the Statute of the European System of Central Banks and of the European Central Bank (the legal framework for the Eurosystem), losses borne by an NCB are not automatically shared; losses may only be shared pursuant to a capital-key weighted majority decision by the Governing Council.

Evidence

1) Plain Reading: Paragraph 2 of Article 32.4 states that the “Governing Council may decide that national central banks shall be indemnified… in exceptional circumstances for specific losses” (emphasis added).

We are not quite sure whether the use of “exceptional” in Article 32.4 is intended to refer to a decision on loss sharing (meaning loss sharing only happens in exceptional circumstances) or whether it is descriptive (meaning losses themselves could only occur in exceptional circumstances). Under either interpretation the sharing happens only pursuant to a Governing Council vote. In the event of a large loss such mandatory vote could easily be anything but pro forma.

Article 10.3 of the Protocol provides that for any decisions taken under Article 32, inter alia, “the votes in the Governing Council shall be weighted according to the national central banks’ shares in the subscribed capital of the ECB.”

2) The One Public Decision to Share Potential Losses: Due to counterparty defaults in 2008, the Bundesbank, the Dutch National Bank and the Luxembourg Central Bank seized collateral of defaulting counterparties and faced potential losses on its disposal. The Governing Council voted that potential losses arising from these operations should be shared (it is unclear whether or not losses ever materialized.)

Karl Whelan claims that this decision “clarifie[d]… that losses should be shared in full by the Eurosystem NCBs in proportion to their ECB capital key shares.” But that understanding is hard to square with the ECB’s press release on the matter. The ECB made a specific decision in March 2009, and nothing in it supports Whelan’s argument that they took that opportunity to clarify Article 32.4. In fact the whole exercise suggests loss sharing is not automatic, but only enacted pursuant to a vote (as Article 32.4 requires) after making sure, for instance, that all rules were followed.  The press release discusses specific potential counterparties and losses; it does not contemplate any future events or decisions.

ECB Press Release:

5 March 2009 - Eurosystem Monetary Policy Operations in 2008

The year 2008 has been exceptional, also in terms of Eurosystem’s monetary policy operations. The intensification of the market turmoil and the changes to Eurosystem refinancing operations led to an increased level of activity by the Eurosystem to support the financial sector and, through it, the entire economy.

The Eurosystem income from monetary policy operations is expected to amount to some € 28.7 billion in 2008, higher than in 2007 (€ 23.2 billion). The income from Eurosystem monetary policy operations is redistributed among national central banks (NCBs) in proportion to their shares in the ECB’s capital. However, net results of individual NCBs follow different patterns, due to the historical structure of their balance sheets, some specific national responsibilities and national accounting practices. The aggregate net result of the Eurosystem NCBs, including the distribution of the net result of the European Central Bank (ECB) that they receive, is estimated to amount to approximately € 16.8 billion for 2008. The year before, the aggregate net result was € 15.2 billion. The result of the ECB itself for 2008 amounted to EUR 1.3 billion in 2008, compared with zero in 2007 (see today’s ECB press release on the ECB annual accounts for 2008).

At the same time, the specific circumstances of 2008 also implied higher financial risks in Eurosystem credit operations. In autumn 2008, five counterparties defaulted on refinancing operations undertaken by the Eurosystem, namely Lehman Brothers Bankhaus AG, three subsidiaries of Icelandic banks, and Indover NL. The total nominal value of the Eurosystem’s claims on these credit institutions amounted to some €10.3 billion at end-2008. The monetary policy operations in question were executed on behalf of the Eurosystem by three NCBs, namely the Deutsche Bundesbank, the Banque centrale du Luxembourg and de Nederlandsche Bank. The Governing Council has confirmed that the monetary policy operations in question were carried out by these NCBs in full compliance with the Eurosystem’s rules and procedures, and that these NCBs had taken all the necessary precautions, in full consultation with the ECB and the other NCBs, to maximise the recovery of funds from the collateral held.

The counterparties in question submitted eligible collateral in compliance with the Eurosystem’s rules and procedures. This collateral, which mainly consisted of asset-backed securities (ABSs), is of limited liquidity under the present exceptional market conditions and some of the ABSs need to be restructured in order to allow for efficient recovery. Under current market conditions, it is difficult to assess when the eventual resolution will be achieved by the Eurosystem.

The Governing Council decided that any shortfall, if it were to materialise, should eventually be shared in full by the Eurosystem NCBs in accordance with Article 32.4 of the Statute of the ESCB, in proportion to the prevailing ECB capital key shares of these NCBs in 2008. The Governing Council also decided, as a matter of prudence, that the NCBs should establish their respective shares of an appropriate total provision in their annual accounts for 2008 as a buffer against risks arising from the monetary policy operations which were conducted with the counterparties mentioned above. The size of the total provision will amount to € 5.7 billion, and it is already accounted for in the net result figures stated above. The level of the provision will be reviewed annually pending the eventual disposal of the collateral and in line with the prospect of recovery.

3) No ECB decisions have codified that losses are to be shared in the future. Some decisions have referred to the sharing of monetary income and have periodically updated the calculation of monetary income.  In December 2009, the ECB decided that NCB’s should not suffer a hit to their monetary income when interest bearing loans to counterparties are transformed into non-interest bearing claims against the defaulted estate.