How to make free money less attractive in a credit crunch

The European Central Bank’s Quarterly Bank Lending Survey didn’t draw much attention this week, which is no surprise. Headline results – that European lenders expect credit access to be tight this quarter as higher rates weigh on demand – were hardly shocking news.

But drill down into the details and it’s clear how quickly credit conditions are deteriorating, making predicting one aspect of Thursday’s ECB meeting unusually difficult.

Lending standards for European non-financial corporations have returned to peak levels seen in the eurozone crisis, with Italian borrowers being hit the hardest. Mortgage and consumer credit are as tight as they were in 2008, led by a tightening in Spain and Germany.



Demand for corporate credit has been kept artificially high this year by slow supply chains and rising production costs. This effect now seems to be wearing off. . .


… but for households the slump in demand looks well advanced:


The ECB’s Lender Survey typically forecasts downstream credit supply by about a year. The pace of the easing since June, when the ECB announced the end of negative interest rates, “confirms our view that the eurozone is headed for a deep recession,” Barclays said.

© Barclays

As lending standards vary from country to country – shaped by labor markets and sovereign-bank relationships – the financial industry’s response has been mixed. Lenders in Spain, Austria and Belgium have restricted lending much more than in the Netherlands, Ireland and France. Charts over Redburn:

A deteriorating macro environment, with higher interest rates (hence borrowers’ funding problems) points to European banks’ risk costs more than double the 0.40 basis points currently assumed by the market, Redburn estimates.

A doubling of the cost of risk would bring the sector’s valuation back to its long-term average of 10x forward earnings versus its alleged bargain level of 6x now. None of the ratios deserve much attention as they are just snapshots, not guidelines. Ultimately, where the cost of risk peaks depends largely on how much unemployment rises. And at today’s prices, investors seem to be assuming it won’t rise more than a few percentage points.

For this reason, it makes sense to take a close look at European unemployment expectations. Employers in the Netherlands and France are optimistic; those in Eastern Europe, Italy, Germany and Belgium do not:

All of this can be put on a scatterplot:

We are often reminded that in the average rate hike cycle, the margin boost banks get from rising interest rates tends to eclipse weaker credit growth. But a deeper recession also means banks will have to work harder to secure broad funding, which is already showing some signs of deterioration:


Another thing to remember is that capital buffers are ridiculously high across the European banking sector:

© Barclays

Still, signs of more restrictive large-scale funding come at an awkward time for the ECB as it has to scale back its pandemic-era loan subsidies, known as targeted longer-term refinancing operations. Banks can borrow almost free through TLTRO and then park their excess liquidity with the ECB’s overnight lending facility, which currently pays 0.75 percent.

Barclays estimates that about €1.1 trillion of the €2.1 trillion in TLTRO’s outstanding loans was used for ECB deposit arbitrage. If the system were left in its current form at higher interest rates, the ECB would pay around 110 billion euros to banks in the euro area over the next 12 months for no good reason.

However, with about two-thirds of TLTROs repayable in the first half of 2023, a full pullback would pose cliff risk, particularly for peripheral economies:

The ECB could reduce the attractiveness of TLTRO arbitrage by repricing outstanding loans to match its deposit rate. Or it could apply some sort of tiering threshold to parked reserves. The simple approach to tiering would be to exempt a percentage of TLTRO loans from interest on deposits – but that could choke liquidity in Italy and Spain and create very little incentive to repay loans.

A trickier solution would be to avoid direct action and use Swiss National Bank-style reverse tiering, which stops paying deposit interest on liquidity exceeding an arbitrary threshold. Overfunded banks would be encouraged to repay their TLTROs to avoid the effective penalty, while underfunded banks would still have access to the carry trade.

Here’s how it looks across the zone, with the threshold set at 6x reserve requirements and again at 25x.

© Barclays

Too complicated? Too political? Probably right now, all things considered. So analysts are expecting nothing more than slight adjustments to deposit terms this week. Here’s Barclay’s:

We think the ECB is likely to intervene directly, as reverse tiering would carry a greater risk of damaging monetary policy transmission. With approximately 65% ​​of TLTRO credits maturing by June 2023, which will reduce excess liquidity, we believe the least disruptive strategy for the ECB would be to simply wait and see.

Read  How to plant balled-and-burlapped trees

Leave a Comment

Your email address will not be published. Required fields are marked *