It’s been a year since the European Central Bank (ECB) all but bailed out the euro zone’s banks. In December 2011 and February 2012 the ECB provided them with a total of €1.02 trillion ($1.34 trillion) in the form of three-year cheap loans, as a way to encourage them to lend more to businesses, consumers and each other.
These long-term refinancing operations (LTROs) included one necessary caveat: if they wanted to, banks could repay the money a year or more into the operation and get out of the deal. At the time, this was a way to convince investors that they wouldn’t be stuck holding euros if the currency collapsed altogether. It also gave stronger banks the flexibility of getting out if they wanted to explore other deals. This moment is now at hand: Banks that took part in the first LTRO can start repaying the ECB after Jan. 30.
And now Morgan Stanley’s Global Head of FX Strategy, Hans Redeker, foresees a problem. If some banks leave the LTRO earlier than others, the ones that stay behind might feel pressured to pay up before they’re really ready:
Bank business is about trust and reputation. Balance sheets are important not only with respect to funding costs, but also for what they say about the bank’s creditworthiness. What banks try to avoid at all costs is stigmatization. Using long-term ECB funds is fine, as long as all banks use these funds. However, once stronger banks withdraw from LTRO funds, other banks will not want to be seen as remaining dependent on central-bank funding.
Should banks begin to pay back LTRO funding, the ECB would see the monetary transmission mechanism weakened once again. Weaker banks repaying LTRO funding could force them to shrink their balance sheets, leading the EMU banking industry to seize up again – a development the ECB is unlikely to tolerate.
Redeker goes on to suggest that an interest rate cut from the ECB—the bank’s governing council meets on Jan. 10—could diminish some of this funding stress, but it’s unclear that this would really prevent weak peripheral banks from being stigmatized.
So far, a number of banks headquartered in core Europe have said that they’ll return LTRO money early. Analysts at Barclays estimate that banks could return a total of €200 billion. Some €80 billion of that could come from France which, despite persistent concerns about growth, has been seen as a relative safe haven since last year.
But Barclays also thinks Spanish and Italian banks could repay totals of €30-40 billion and €40 billion, respectively, and they are more rickety. Spain’s banks are only just receiving the first installment of a European bailout worth up to €100 billion. Although not all of those that might need aid are getting it right now, most Spanish banks are close enough to the edge that they’ve been forced to cut off pieces of their operations. The strongest, Banco Santander, has sold off units in Europe and Latin America to bolster its core businesses. Repaying the ECB early may help their reputations, but reputations won’t give them cash and get them lending again.
This is one reason an insider who’s been privy to the EU-level discussions of banking union believes there’s a severe and ongoing credit crunch in Europe’s banks that the LTRO has not fixed. Although markets seem calm, the insider cautions, “You can’t have a strong bank in a weak country.” ECB president Mario Draghi’s promises to “do whatever it takes” to save the euro may have staved off disaster, but the insider said there’s little actually being done to stop the slow encroachment of long-term recession: “Privately, even people at the ECB don’t expect the recession to end in 2013,” public statements to the contrary.
With Portuguese and Greek bonds offering some of the best returns of 2012 amid occasionally promising economic data, some US and northern European funds are making forays back into riskier areas, looking for a returns in a world of low yield. But these speculative adventures are few and far between. And they mask a deeper disease. As the first banks begin repaying some of the money they borrowed in the LTROs later this month—and as political turmoil threatens Italy—the failings in the banking sector may once again bubble to the surface.