Now is as good a time as any for the ECB to start discussing measures to increase liquidity, as well as deal with a broken transmission mechanism.
Divyang Shah
IFR Senior Strategist
The evolution of excess liquidity will require the bank to act, and press reports suggest it is looking at tying its liquidity operations to increased lending to SMEs. The question is whether the banks are incentivised enough to participate in any new LTRO.
We have been talking about a modified liquidity operation for some time (Full Story) and the ECB has raised the possibility of conducting further LTROs, but we are finally seeing some flesh being put on the bones. A German newspaper is reporting that the ECB is looking at an LTRO in order to help promote bank lending, especially to businesses.
According to Sueddeutsche Zeitung, the ECB is looking to provide a new LTRO with the view that the banks increase lending and that the operations would be conducted with a term of 9-12 months. The 3-year LTROs did not have the desired effect in that banks simply engaged in the sovereign carry trade, so some form of modification is certainly justified.
What’s in it for us?
How banks are incentivised to participate in the new LTRO remains to be seen, as the 9- to 12-month term cited in the report does not seem long enough to encourage participation. A much longer term LTRO (beyond 3-years) conducted at a fixed/lower rate over the life of the LTRO would likely prove more successful, especially as the carry trade is now less attractive. The ECB will also need to make clear that those engaging in the LTRO will not be at a disadvantage when it comes to the stress tests next year.
If the ECB wants to stick with a 9- to 12-month LTRO then it could look to conduct such operations every quarter and assure banks that the operations will continue for at least the next three years. The advantage of this is that it would allow the ECB to deliver further modifications should they be deemed necessary.
Talk is cheap, but the report increases the chance that an announcement could take place as early as the December ECB meeting next week. In addition to a modified LTRO we would also not rule out the prospect that the ECB will 1) cut the deposit rate to -0.1%, 2) reduce the reserve requirement, or 3) leave the SMP program unsterilised as additional measures to improve excess liquidity.