Dramatic contraction of 1.1 trillion. Euros is expected to be received by the liquidity of European banks by 2024, after more than a decade of cheap money from the European Central Bank, with the biggest “test” expected on June 28 of this year when they will have to “pay” the central bank 477 billion euros. This amount refers to the cheap long-term loans, known as TLTROs, that the ECB has granted to the sector after the outbreak of the pandemic in 2020 so that they can continue to support the economy in the midst of generalized lockdowns.
From the fourth quarter of 2022, the banks of the Eurozone have begun to repay early these loans which had peaked at 2.2 trillion. euros in mid-2021 (or to 20% of the total liquidity of the Eurosystem) following a relevant recommendation of the ECB in the context of the strategic reduction of its balance sheet. So far, in small installments, around 900 billion euros have been repaid without significant effects on the market so far.
The program of targeted long-term refinancing operations, TLTRO III, allowed banks, in addition to granting loans to businesses and households, to increase their liquidity cushions, as well as to strengthen their sizes since they were borrowing from the ECB at a negative interest rate that reached up to and -1%, much lower than the interest rate of the ECB deposit facility. The ECB has even calculated that these loans reduced lending rates by up to 60 basis points, which is equivalent to a large rate cut. Some banks also increased their profitability by taking these loans and redepositing them back to the ECB to earn higher interest.
From November 2022, however, the central bank changed the terms of TLTRO III, encouraging banks to repay these loans early. As the ECB has raised interest rates faster than expected due to soaring inflation, European banks have been benefiting from both these ultra-cheap three-year loans and higher interest rates, effectively a “subsidy” from the ECB to the banks. The ECB thus considered that it was necessary to adjust this program in order to ensure that it is compatible with the wider monetary policy normalization process and to strengthen the transmission of increases in policy rates to bank lending conditions.
Thus, the interest rate of these financing operations is now linked “to the average applicable key interest rates of the ECB for the specific period”, according to a related announcement.
European banks have certainly improved their liquidity and funding positions both in the last decade and since the global financial crisis, they are much better capitalized, while the non-performing loan ratio reached an all-time low of 1.8% at the end of 2022 .
The TLTRO payouts, however, are a major milestone for the industry after the recent US and European bank shocks rocked markets in March and called into question investor confidence in the system, with market focus turning to potential liquidity and funding problems that some banks may face. The large “dose” of 477 billion euros in June, as well as the definitive end of this support that exceeded 2 trillion. euro, will increase pressures on banks, especially the most vulnerable, worsen already tighter credit and lending conditions, and raise funding costs, which could hit economic growth.
According to calculations by Allianz Research, the withdrawal of the TLTRO as a source of cheap funding for banks will reinforce the current decline in credit growth (annualized) by about 1.4% each month on average. In terms of markets, it expects a non-negligible impact on corporate credit risk pricing, with corporate bond spreads widening by as much as 50 basis points.
The International Monetary Fund in its recent report on financial stability warned of these effects. “European banks may need additional liquidity support when the mandatory repayments of long-term refinancing operations (TLTROs) come to an end. Looking at the share of TLTROs maturing to June 2023 against excess liquidity available for repayment reveals potential fragmentation risks – banks in some southern European countries that continue to rely heavily on short-term TLTROs tend to be the same ones that do not they have enough excess liquidity to repay,” the IMF noted.
Analysts and investors will be closely monitoring the liquidity coverage ratio (LCR) of European banks in the coming period, which essentially measures how much readily-sold assets, such as bonds, a bank has compared to its deposits, i.e. the its ability to meet short-term obligations. According to the regulatory framework, the minimum limit of the index is 100%.
According to calculations by Deutsche Bank, the balances held by European banks at central banks amount to 3.4 trillion. euros, so there is an excess of 2 trillion. euros compared to 100% which is the minimum coverage ratio required. However, banks want to have a “safe” surplus, with the ratio reaching 130% rather than 100%, meaning there is effectively €880 billion of excess liquidity in the system.
Deutsche Bank estimates that the average LCR after the full repayment of TLTRO III will decline from 153% at the end of 2022 to around 135% across European banks. This is still well above the regulatory minimum of 100%, but is perhaps closer to the 130% level that banks wish to have.
The TLTRO program is financing facilities with guarantees (collaterals). Banks deposit collateral with the ECB (with a specific haircut) in exchange for liquidity. Some of these collaterals are high quality liquid assets (HQLA), but not all. When the TLTROs are repaid, liquidity will decrease but the banks get back the collaterals they had “deposited” with the ECB. Thus, depending on the type of collateral, it can make a significant difference to the impact of a bank’s liquidity when it comes time to repay.
IMF / IMF Global Financial Stability Report April 2023 Update
“Banks in some southern European countries that continue to rely heavily on short-term TLTROs tend to be the ones that do not have enough excess liquidity to repay them,” the IMF noted in the financial stability report.
477 billion euros must be “paid” by European banks to the ECB on June 28 from the cheap TLTRO loans they have received.
According to Allianz Research, the withdrawal of the TLTRO as a source of cheap funding for banks will reinforce the current decline in credit growth by about 1.4% each month on average on an annual basis, while leading to a widening of corporate bond spreads.
