Two years ago, the European Central Bank lent a trillion euros at remarkably cheap rates to EU banks under a program called LTRO. What did the banks do with all that money, and why are many of them returning it early?
On Wednesday (13.8.2014), ten European banks were scheduled to repay a total of 4.15 billion euros to the ECB. Similar repayment amounts have been flowing weekly, as the banking system returns, in rivulets and trickles, a vast tsunami of money with which the ECB deluged Europe's banks two and a half years ago under a program called Long-Term Refinancing Operations (LTRO).
On two special days, December 21, 2011, and March 1, 2012, the ECB was willing to lend any amount of money to any bank in the eurozone on the most generous terms it had ever offered. No bank was turned away - as long as it could put up adequate collateral as security in case of loan default.
In the lead-up to the two special lending days, the President of the ECB traveled the continent giving speeches urging any and all European banks to send in loan requests.
By the time the smoke cleared at the close of business on March 1, 2012, a total of 1,323 banks had availed themselves of Draghi's invitation. The ECB had lent a colossal 1019 billion euros ($1589 billion) to the banks under what it called its Longer Term Refinancing Operations (LTRO) program.
The reason for the momentous bargain: The ECB was worried that if it didn't do something of overwhelming scale to inject "liquidity" into the banking system, a general financial and economic collapse mght ensue.
Weaker banks were at risk of becoming unable to meet their payment obligations as depositors deserted them for safer havens. Economically depressed southern nations were being pushed to the point of insolvency as they found it more and more expensive to refinance their huge accumulated debts at ever higher interest rates. Real-economy businesses in crisis regions were unable to obtain credit as their banks hunkered down to wait out the continent's financial storm. All economic signs pointed downward.
The eurozone's entire financial weave was at risk of unraveling.
"During 2011, the tensions in sovereign debt markets in the euro area increased, funding pressure on banks in the crisis countries mounted, and credit availability for households and non-financial firms became severely impaired. The crisis was spreading from the smaller peripheral countries - Greece, Ireland, Portugal - to Italy and Spain, where the funding conditions of governments and banks were deteriorating dramatically," said Philipp König, a banking system expert at the German Institute for Economic Research (DIW) in Berlin.
That's why the ECB pulled out what some observers called its "big bazooka".
Central bank money rescued the eurozone banks - and sovereigns
The ECB's solution was to pull out all the stops on its LTRO program. In essence, it overwhelmed financial markets' doubts about any particular bank's "liquidity", its ability to pay its bills, by lending almost limitless amounts of money to almost any European bank on very easy terms, for much longer loan periods than ever before.
Prior to the financial crisis that began in 2008, the ECB had lent money for a maximum of three months, generally in modest quantities to banks in special trouble.
After the global financial crisis began 2008, the ECB rapidly extended the term of loans from its LTRO program to six, nine, and then twelve months, and it removed caps on total lending under LTRO.
Moreover, the ECB progressively relaxed collateral standards with each round of LTRO financing. It accepted an ever wider range of securities.
But by late 2011, it was clear that the steps taken so far hadn't been enough. The whole of Europe was anxiously waiting to see whether the government of Greece would default on its bond payments, and no-one knew how many Greek bonds were stuck in the asset portfolios of banks in Spain, France or Germany.
The financial system was unsure about the solvency of whole countries, as well as the banking systems of those countries, which tended to own large quantities of sovereign debt from their home nations.
Central bank rewrote the rules
The big bazooka had three new features compared to previous LTRO rounds. First, it extended loan terms to three years - which meant that financial markets no longer had to worry about whether any given bank would have enough cash on hand to be able to make short-term payments. The "liquidity" issue was pushed so far off into the future that it was effectively off the table.
Second, it dramatically relaxed collateral quality standards. Whereas previously, only high-quality, low-risk assets like sovereign bonds of financially healthy countries were acceptable as collateral, now the ECB would accept packages of loans made by the banks themselves - portions of each bank's loan portfolio.
"Our second measure will allow banks to use loans as collateral with the Eurosystem, thereby unfreezing a large portion of bank assets. It should also provide banks with an incentive to abstain from curtailing credit to the economy and to avoid fire-sales of other assets on their balance sheets," ECB President Mario Draghi said in a Berlin speech on December 15, 2011, a few days before the central bank opened its three-year LTRO wicket.
Third, the ECB made it clear that there was no longer any stigma attached to borrowing from the LTRO program.
Previously, turning to the ECB for funding was seen by financial markets as a sign that a bank had lost the trust of the interbank funding market, which was a sign of possible insolvency. The perception could cause other banks to avoid doing business with it. The reputational damage was likely to hit the bank's share price as well.
Now, in December 2011, Mario Draghi was at pains to underline that these concerns no longer applied.
"We want to make it absolutely clear that in the present conditions where systemic risk is seriously hampering the functioning of the economy, we see no stigma attached to the use of central banking credit provisions: Our facilities are there to be used," he said.
Where the money didn't go
The bulk of the ECB's tsunami of money didn't end up in the "real economy". Most of it never left the banking system's accounts at the central bank.
This isn't as shocking as it sounds. The ECB didn't lend banks what regular citizens use as "money" through the LTRO program. It lent them a special form of inter-bank scorekeeping money called "central bank reserves", or simply "reserves" for short.
Reserves are used exclusively to enable settlement of inter-bank obligations. Banks use reserves to buy financial asset titles from each other, to settle debts that arise when their clients send money from bank to bank, or to buy sovereign bonds from the government, but reserves cannot be directly lent out to the public.
A bank with enough reserves to meet its interbank settlement obligations is "liquid"; a bank with insufficient reserves is "illiquid".
For those interested in learning more, Paul Sheard, chief economist of Standard and Poors, wrote a report published by S&P in August 2013 entitled "Repeat after me: Banks cannot and do not 'lend out' reserves".
And the Bank of England published an eye-opening report in its 2014 Q1 Quarterly Bulletin entitled "Money creation in the modern economy".
Where the money went
Different banks did different things with the reserves they borrowed under LTRO, but DIW economist Philipp König said that some large-scale trends can be discerned.
Huge rivers of money flowed from southern to northern Europe during the height of the European banking crisis in 2011, as people and businesses with financial holdings in southern Europe went looking for safer havens to store their wealth.
The ECB's LTRO program rescued southern banks' ability to pay out their fleeing depositors.
"Southern banks used the liquidity from the ECB's LTRO program to meet withdrawals and outflows of deposits, which were often channeled to banks in the non-crisis countries. It's questionable whether banks in crisis countries could have been able to support the continued funding outflows without the massive liquidity injections from the LTRO program," according to DIW's Philipp König.
As a result of the South-to-North flow, Northern banks accumulated large excess reserves in their accounts at the ECB. Many of them, says König, simply sat on the reserves. But some used them to buy financial papers from other banks, or to buy sovereign bonds from the government.
The latter trade was particularly attractive. In mid 2012, Spanish and Italian sovereign ten-year bonds paid 4.9 percent annual interest. Eurozone banks able to borrow from LTRO at one percent interest - provided they could provide the ECB with adequate collateral - could turn around and buy bonds at 4.9 percent, for an instant profit spread of 3.9 percent.
Borrowing money cheaply at one interest rate and investing it elsewhere at a higher interest rate is called a "carry trade", and the LTRO's trillion-euro bonanza enabled a large and lucrative carry trade.
Banks in financially strong parts of the eurozone that were piling up reserves as money rushed in from crisis regions didn't even need to borrow from LTRO - they could simply use their excess reserves to buy sovereign bonds and pocket the entire 4.9 percent.
These easy profits - insofar as they were retained on the banks' balance sheet, not paid out in dividends or bonuses - may have helped restore the capital cushion of some banks, returning them from the brink of insolvency.
It was the southern banks that were badly in need of additional "liquidity", or central bank reserves, not the northern banks. That's why the bulk of the LTRO's lending was to banks from crisis-region countries.
But the majority of the LTRO money has already been repaid, even though bankers could have held onto it for longer than they did. The terms of the LTRO loans were that borrowers could begin repaying after one year, but could also keep the money for up to three full years.
Despite Draghi's insistence that there was no longer a stigma associated with borrowing ECB money, market participants clearly felt differently. LTRO loans have been repaid to the ECB even when lucrative carry trades remained available.
LTRO was the ECB's boldest and biggest move in its bid to rescue Europe's banks
The three-year LTROs proved to be perhaps the single most important policy move in the ECB's ever more expansive post-2008 "non-standard monetary policy." The enormous loan packages were an audacious gambit that was at least as important to restoring calm in European financial markets - and ending fears of a eurozone breakup - as ECB chief Mario Draghi's famous promise to rescue the euro.
"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough," he said at an investment conference in London in July 2012.
By the time he said that, he had perhaps already done what it would take. Lending a trillion euros of reserves to Europe's banks had multiple useful effects, benefiting not just the individual banks, but also the stability of the banking system as a whole, and the solvency of sovereign borrowers.
"With respect to easing conditions in money markets, the ECB indeed met its objectives," Philipp König said. "However, it is hardly possible to assess to which extent the ECB's measures helped to prevent credit conditions from deteriorating even further.
"But it is clear that the ECB, at that time, could not have done much else to support credit conditions. Other determinants of credit supply, like the prospects of individual borrowers, or the risk exposures of individual banks, are outside the ECB's reach."
The struggle continues
It's not over yet. Much of southern Europe remains mired in stagnation, and troubling signs of deflation are arising. Now the ECB is preparing for yet another round of LTRO - this time called TLTRO, or Targeted Long Term Refinancing Operations, intended to incentivize Europe's banks to make loans to real-economy non-financial businesses.
It's hard to say whether the latest incarnation of LTRO can succeed in stimulating the real economy - because the same basic challenge remains: a shortage of willing and qualified borrowers, especially in the hard-hit crisis regions. Even if the banks become more willing to lend, the borrowers Draghi hopes for may collectively stay away.