Tuesday, June 4, 2013

Three-Year LTRO - Claiming Undue Credit

Speaking in London Thursday
 (at 8:53), ECB President Draghi made the following claims about the impact of the three-year LTROs  (deviations from the ECB published text are in red  (published text): 

"In late 2011 and early 2012 we launched two 3-year long term refinancing operations which we called LTROs. These operations [Our LTROs]  gave banks sufficient reassurance that access to liquidity will not be a problem over a relevant planning horizon. We injected about €1tr, gross injection of liquidity with two operations which took place, one in January [sic] and the second in February of 2012.  60% of this has been repaid already. Without these operations, banks would have defaulted on their maturing obligations or would have discontinued and withdrawn existing credit lines to companies. One should remember that in the first quarter of 2012 230bn of bank bonds were maturing and more than €300bn of soveign bonds were maturing.  That's why banks in fact stopped giving credit starting in July of 2011, and that's where a good deal of the current credit crunch comes from.  The LTROs therefore helped to avoid a major credit crunch."

This is consistent with previous claims Draghi made about how the LTROs prevented a credit crunch due to refinancing difficulties in the first quarter of 2012:
  • "[E]specially the LTROs, basically avoided major disasters which were looming ahead of the funding crunch that characterised the first quarter of this year. As I have told you many times, there were bank bonds worth about €230/€260 billion falling due." December 2012
  • “Let us not forget that in the first quarter of this year, more than €200 billion of bank bonds fall due. So this decision certainly prevented a potentially major funding constraint for our banking system, with all the negative consequences this might have had on the credit side.” January 2012
  • “[W]ith the first LTRO, we avoided a major credit crunch.  I have already said that  €230 billion worth of bank bonds were coming due in the first quarter [t]he LTRO addresses the quantitative shortages and liquidity constraints of certain parts of the euro area financial and banking system.” February 2012

But Draghi's claim, that the market dysfunction seen in November 2011 was due, in part, to an inability by banks to predictably access term financing, cannot be true for the following reasons:
  1. On October 6 the ECB had announced a one-year LTRO for October 26 and thirteen-month LTRO for December 21. 
  2. The ECB was already offering unlimited liquidity through its standard instrument, the MRO, since October, 2008, and had promised to continue this ‘fixed-rate, full-allotment’ policy ‘as long as necessary, and at least until the end of the sixth maintenance period of 2012 on 10 July 2012’.
  3. In addition to the unlimited MRO, the ECB has a standing discount window facility, the MLF. It has always been unlimited and available on a daily basis. The rate has been fixed since May, 2009 at 50-75 basis points over the MRO rate.
The difference in term between the three-year LTRO and and these instruments is meaningless in the context of preventing an imminent disorderly deleveraging in the first quarter.   

In addition, the three-year is not really a "long term" repo:
  • The haircuts on the LTROs are the exact same as the standard one-week policy instrument, the MRO.  Both haircuts and eligible collateral can change at any time.
  • Since the LTRO rate floats with the ECB’s policy rate, there is no economic difference for a bank between the LTRO and the weekly MRO. The three-year LTRO costs the same as rolling the MRO for three years[1].  

[1] If the ECB returns to its pre-October, 2008 mode of variable-rate tenders, and a period of stress comparable to the fall of 2008 occurs without a concomitant return to the fixed-rate, full-allotment policy, the LTRO may offer a microscopic benefit to its users.

An Alternate Explanation

The European crisis in late 2011 centered around Italy where short-term spreads were rising rapidly.  Concern over the increasingly erratic behavior of the long-serving Italian Prime Minister, Silvio Berlusconi, combined with fears about Italy's high level of public debt to create a panic.  The circus of Berlusconi's leadership is well captured by this smirk, shared by then French President Sarkozy and the German Chancellor Angela Merkel at an EU crisis summit in late October 2011.

Mr. Berlusconi's replacement by the technocratic Mario Monti was a significant change.  For one, the risk of the Berlusconi doing something dramatic, like pulling Italy out of the Euro or defaulting on Italy's debt, was immediately reduced.  In contrast, Mr. Monti first step was to appoint a cabinet of technocrats and to propose an agenda of structural reforms.  A simple event study suggests that the drop in Italy's rate of borrowing was far more likely caused by Mr. Monti's arrival than the LTRO:

*The spread closed 95 basis points on December 5. 

While the above chart certainly proves nothing, the question remains: is it more likely that Italian spreads fell in late 2011 because of a central banking instrument that offered financial institutions no new benefit or a radical change of government in Italy?


  1. So what is your explanation for the similar, almost parallel development of Spanish yields? While one can imagine some benefit from radical change of Italian government for Spain, why would they move so much in tandem? Shouldn't the gap between Italian and Spanish yields have narrowed after Italian government change?

  2. Great question - the spread in the 3-year was Italy +100 basis points on October 1, 2011. It was Italy +270 bps on November 7 but by March 1, 2012 the same spread was 0 bps.

  3. Well March 1, 2012 isn't in your graph above. That seems like cherry-picking data.

    It seems to me your original argument was that the forming of the Monti government caused Italian yields to drop quickly, in a matter of weeks, not months (see your graph).

    Another way to put this: Why don't you draw the Italy - Spain spread in the above graph? Then we can easily see whether it falls or not after new Italian government announced. If that spread stays constant or even widens that would be evidence against your argument about the true cause of the decline in Italian yields.

  4. Its not cherry picking as the spread widened further to Spain's detriment after March 1. You raise a good point about showing the Spain/Italy spread over the time - perhaps we can address that in a later post.

    Still - the question remains whether a meaningful government change in Italy or a central bank refinancing operation with no economic substance was more likely to have caused the spread decline.

  5. To play devil's advocate: Even mere talk by Draghi can move prices. Just like government change per se can move prices. But neither Draghi talk nor changing personnel or who is the prime minister changes anything real, it is the actions that markets expect that will be taken that matter. So if Draghi says something markets adjust expectations (of future monetary policy) and thus prices, if identity of prime minister changes markets adjust expectations (of future fiscal policy) and thus prices.
    Just saying that this was meaningless is simply not enough in the context of macro. All these prices are much more dependent on expectations about future actions, than about past actions themselves.
    So you may very well be correct, but unfortunately your arguments/evidence are too weak to conclude that the ECB takes undue credit.......Quite unfortunate. Work harder :-)