Updated: UK Commissioner called back for second hearing – what happens now?

A couple of developments since we posted the original blog below.

Importantly, the European Parliament’s Economics Committee failed to reach an agreement over Pierre Moscovici and has delayed a decision on whether to approve him or not until 9.30pm CET tonight. Given his clear knowledge and experience in the area as a former French Finance Minister, the objection is clearly being driven by a fundamental split between the EPP (led by the CDU) and the S&D (led by the French socialists) over whether he is the right man for the job given his political allegiances and the fact France has repeatedly missed the deficit targets agreed with the European Commission over the past few years.

As regards Lord Hill, @Brunobrussels points out that a letter will be sent by European Parliament President Martin Schulz to Commission President Jean-Claude Juncker outlining some key questions for the UK’s nominee. It is unclear exactly what these questions will include, but the focus will be on his knowledge of issues such as the banking union, Eurobonds and financial regulation in general. There may also be questions around exactly what will be under his purview and his relationship with the Vice-Presidents. It also seems that concerns over Hungarian Commissioner Tibor Navracsics are growing, as we warned here. Overall, the process is at risk of descending into in-fighting and horse trading between the EPP and S&D (if it hasn’t already) – and Lord Hill has certainly got caught up in that.

 ********************* Original blog below **********************

UK Commissioner designate Lord Hill yesterday faced the European Parliament’s Economic and Monetary affairs committee which has to judge if he is suitable for the proposed role of Commissioner for Financial Services, Financial Stability and Capital Markets Union. 

While Hill went out of his way to charm MEPs, in what the FT terms an “unprecedented move” the committee has recalled Hill for a second hearing early next week (likely Monday), reportedly due to concerns over his lack of detailed knowledge of the brief.

Having watched the hearing it was clear that Hill struggled on the minute details of some of the more technical questions from MEPs, some of whom have been dealing with this area for years. However, even some members of other UK parties have come to Hill’s defence. Labour MEP Richard Corbett wrote on his blog: 

“When all is said and done, he performed far better than many of the other candidate Commissioners.”

 Former Lib Dem MEP and Chair of the EP Econ committee Sharon Bowles tweeted this morning: 

“If you only give commissioners designate 2 weeks to prepare, on sensitive dossiers second hearings/written follow up inevitable.”

Having watched the other Commissioner hearings Hill is certainly not alone in struggling to come up to speed in such a short time. For example, the centre-right EPP group has issued a stark criticism of Commissioner-Designate for Regional Policy Corina Creţu for failing to provide details on how she will tackle the build-up of delayed cohesion payments. Employment Commissioner designate Marianne Thyssen has also taken flak for not knowing details of the posted workers directive, while proposed Digital Commissioner Gunther Oettinger was criticised for being too vague on surveillance, net neutrality and other specifics of his brief. In short, many Commissioners are struggling to tread the fine line of trying to please all sides in the European Parliament (thereby sticking to vague and uncontroversial answers).

Furthermore, let’s not forget that the outgoing Internal Market Commissioner Michel Barnier – who oversees financial services – had little to no experience of the area before he took over the post having been Agriculture Minister in France.

What happens next?

Hill’s second hearing will likely be early next week. Following the hearing another committee vote/discussion will be held on whether to approve him. These ‘votes’ are informal since the EP does not have direct say over each Commissioner, or which roles they fulfil, but only over the Commission as a whole. There are a few different scenarios over how this could play out:

1) The committee eventually approves Hill: The EP will then eventually have to decide whether to approve the whole Commission. As we have pointed out before, it seems likely that the EP will request that at least one or two of the suggested Commissioners are replaced (if only to flex its muscles). There will then be a negotiation until the EP and Commission President Jean-Claude Juncker (and member states) reach an agreement.

2) The committee does not give Hill approval but he goes ahead anyway: Since the EP cannot veto specific people or roles, it is possible they could reach a deal on the overall Commission set up even without explicitly endorsing Hill. This would certainly hamper Hill in his role since he will be forced to engage with and report to MEPs, however, it should not stop him from fulfilling his brief.

3) The committee does not approve of Hill: In this instance, the committee would fail to approve Hill even after a second hearing and would request he be replaced when they negotiate with Juncker over the final approval of the whole Commission. This would be a difficult negotiation and would raise tensions between the UK and EU. Furthermore, even Cameron were to nominate someone else, it's not clear any UK candidate with direct financial experience/expertise would be more in line with EP thinking and sensitivities. Either way this would be a huge snub and would certainly play into the hands of UKIP and others who want the UK to leave the EU.

4) A re-shuffle: Hill is only one of several candidates who failed to impress MEPs - indeed none of the nominees so far have sailed through, with Spain's Miguel Arias Cañete and Hungary's Tibor Navracsics, both EPP, in trouble (as we predicted) and Slovenia's Alenka Bratusek also facing a tough inquisition. Meanwhile, the EPP could retaliate by blocking one S&D's nominees, with France's Pierre Moscovici the most likely victim. As such, the FT reports there are rumours in Brussels that a "major reshuffle" could be on the cards with the same personnel being moved to 'less problematic' posts. There is a precedent - in 2004, Barroso agreed to swap around a couple of his Commissioners to appease MEPs. Such an approach would fit with the concerns of MEPs which seem to be more centred around the UK having the financial services brief rather than Hill himself.

However, taking financial services away from Hill (even if he is compensated with another big post like Internal Market or Competition) would also be seen as huge slap in the face for Cameron, the City of London, and the UK as a whole. This would probably be the worst outcome in terms of trying to keep the UK in the EU and would play on many of the concerns raised by UKIP.

Ultimately, the most likely scenario remains that Lord Hill is approved albeit with added scrutiny. That said, it seems almost certain the Parliament will request some changes, as it has almost always done, it remains an open question upon whom they will ultimately focus their attention.

Out of the euro but run by the euro? The UK & ECB prepare to lock horns at the ECJ in what could be the most important case yet...

Could euro clearing be moved from the City to the eurozone?

Tomorrow will see the first hearing of the next in the line of important UK cases at the European Court of Justice (ECJ). The case in question is the UK’s challenge against the ECB’s location policy – and it could be the most important of all the cases. The case is shrouded in technical detail but, fundamentally, is whether we're moving towards a two-tier single market and an EU run by the euro for the euro.

Background
On the 5 July 2011 the ECB published its Eurosystem Oversight Policy Framework, which argued:

As a matter of principle, infrastructures that settle euro-denominated payment transactions should settle these transactions in central bank money and be legally incorporated in the euro area with full managerial and operational control and responsibility over all core functions for processing euro denominated transactions, exercised from within the euro area.

In that paper and future opinions the ECB has stressed that it will not provide central bank liquidity to clearing houses outside the eurozone but that all such institutions should have access to it.

The UK quickly challenged the policy in September 2011, calling for the ECB’s policies to be annulled, and has launched two further challenges at the ECJ, in which it updates its list of complaints, the key points of which are as follows:

• The ECB lacks powers in the specified areas, especially since it did not include the plans in a regulation to be adopted by the Council or by the ECB itself, simply decreed it in a policy paper and opinion.
• “De jure or de facto” the rules will impose a residence requirement on clearing houses which want to clear euros, meaning existing clearing houses will face a choice of moving within the eurozone or changing their business approach.
• The rules offend the principle of equality in the single market since firms incorporated in different EU member states will be viewed differently and the rules will not apply equally.
• There are less onerous methods for achieving the same goals (namely security of the financial system) cited by the ECB.

Why is this case so important?
The case manages to combine two crucially important issues:

1. The question of maintaining the EU single market and whether countries outside the eurozone will be dominated by those inside
2. How to ensure the safety, transparency and security of the modern financial system in Europe to avoid a similar crisis to one we have barely overcome

For the UK, there are additional concerns:

• Firstly, it will once again play a role in setting the boundaries of action the ECB and eurozone can take without the non-euro members. It will also create a clearer boundary on what powers the ECB has. 
• If the ruling goes against the UK, there would be a clear split in the single market and, the precedent set, will make it harder for the UK to stay in the EU
• It would raise further questions about whether the UK can trust the ECJ as a neutral arbiter.
• It would undermine the role of the City of London as a financial centre serving the eurozone (the City remains a trading hub for a single currency of which the UK cannot take part), meaning London could lose business to Paris and/or Frankfurt.

Does the ECB have a point?
From the financial stability perspective it is easy to have some sympathy with the ECB’s stance. More and more transactions are being directed on to exchanges and through central counterparties (clearing houses) therefore it makes sense for them to have access to sufficient liquidity. Then again, the LCH Clearnet clears products in 17 different currencies without the need for central banks backstops in all of them.

Given that, and the huge political stakes, one option would be to establish a permanent swap line between the ECB and the Bank of England (or all non-eurozone central banks). Such swap lines are well tested and were used extensively during the financial crisis. In exchange, the ECB would likely require some greater involvement in terms of supervision of institutions which may receive such cash. The easiest and most practical way to achieve this would be through the existing EU institutions such as the European Systemic Risk Board (ESRB) and the European Securities and Markets Authority (ESMA).

Needless to say, the UK also has a strong case since its hard to say this will not hamper the single market at the very least. In any case, whatever the outcome there will likely need to be changes made to accommodate a new structure, hence the repercussions of the ruling will be widely felt.

On what and how might the ECJ rule?
Trying to second guess the ECJ is a hazardous business. That said, this case is interesting because there are a few different elements which the ECJ could choose to rule on or not.

Whether the ECB has competence or not? The first relates to the UK’s first point of challenge regarding whether the ECB has competence in this area. While the ECB does have control of payment systems and gave an extensive legal grounding in its original policy paper its clear that this is a very political decision. Determining who has competence should be a fairly basic question which the ECJ can rule on.

Which has primacy - ECB policy or EMIR? That said, the matter is complicated by the recent European Market Infrastructure Regulation (EMIR). In the preamble point 47 and 52, as article 85 in the main text, all stress that there must be no “discrimination” with regards to where currencies can be cleared and that nothing should “restrict or impede” clearing houses based in other jurisdictions from clearing foreign currencies. As such, the ECJ may have determine who has primacy in this area, as currently it isn’t clear which set of rules should be adhered to (although given that euros are still being cleared in London one might de facto think EMIR is winning). If the ECJ is swayed by the non-discrimination provisions in EMIR, the UK Treasury should be given some credit for pre-empting the ruling - which Open Europe also has recommended.

Does the ECJ actually have anything to rule on? As with the Financial Transaction Tax decision, the ECJ has shown itself reluctant to rule on issues it sees as hypothetical. Given that the rules that the UK are challenging are actually not in place, the ECJ may rule that the challenge is somewhat premature. Obviously, the risk here is that this would be self-fulfilling and act as a catalyst for changes to happen. It would also leave many questions (not least those above) unanswered.

What happens next?
The oral hearing will take place tomorrow. After that the Advocate General will produce an opinion and a ruling will follow, both most likely in a few months’ time.

It’s possible the ECJ could rule on only part of the UK’s claims or support some and dismiss others. It will also be important to see what happens with regards to the primacy of a regulation over the ECB in this particular area which could itself be an important legal precedent (not least because the ECB is becoming increasingly powerful).

It's also still possible that this will be 'settled out of court', given the stakes involved and the risks of unintended consequences.

We'll watch this one closely.

The ECB gives Portugal a helping hand with its return to the markets

Portugal this morning followed the lead set by Ireland and Greece and issued new debt for the first time since its bailout in 2011.

Portugal managed to sell €750m of 10 year bonds at an average borrowing cost of 3.58% and with demand totalling €2.6bn (3.47 times the desired amount). This is a successful return, albeit not quite as large as Greece’s or Ireland’s issuance.

Again, many people will be asking why a country with uncertain funding conditions over the coming years saw such solid demand for its debt, even before it exited its bailout. As with Greece, we would say many of the factors are more to do with the state of the broader market than specific to Portugal:

• The issue remains small with a decent yield – there will always be demand for this kind of risk and return.
• This is particularly true in the current market where interest rates are at record lows and there is a dearth of safe assets which still yield a decent profit.
• The ECB and the eurozone have shown their commitment to keeping the eurozone together and have shown a renewed aversion to private sector write downs on sovereign debt. This combination provides insurance to investors that, even if the Portuguese economy struggles, the rest of the eurozone will ensure that it continues to pay its debts.
• Of course, all that said, the reforms which Portugal have instituted and which have helped boost exports will play some role in encouraging investors.

One specific point to note though is that, on top of the general support given by the ECB mentioned above, it also gave Portugal a more direct helping hand.

Die Welt reported on this issue today, terming it a “trick”. In reality, the ECB has altered its collateral rules so that, when Portugal exits its bailout, its government bonds will still be eligible as collateral for its lending operations. The change was snuck through as part of a package of changes in ECB/2014/10 ‘amending guidelines for ECB/2011/10’ last month.

The ECB’s line seems to be that this was simply a move to bring all the ratings from different agencies into line for collateral, so they correspond to the correct level in the other agencies. This is a fair point, but the timing seems more than coincidental, especially since these rules have been in place since 2011.

The thinking is that, without this change, demand for Portuguese debt would have been limited since it couldn’t be used to gain liquidity from the ECB (we explained here why ratings are still important for just this reason). As such, the ECB looks to have given Portugal a helping hand.

We have written before about concerns over the ECB’s independence during the crisis, particularly in relation to adjusting its technical rules to aid struggling countries. This seems pretty close to falling into that category and highlights that, even though the crisis has eased somewhat, the ECB still finds itself treading some difficult boundaries with regards to its independence.

All that said, this remains a positive, if small, first step for Portugal. Questions remain about whether it will be able to fully fund itself without a credit line from the EU/IMF and whether export growth will be enough to offset the collapse in domestic demand and investment.

Greece exits the wilderness and returns to the markets

It has been labelled by some as the “amazing comeback”. Greece has this morning sold €3 billion of five-year bonds at an interest rate of 4.95% - and the demand exceeded €20 billion.

To be fair, the turnaround in investor sentiment with regards to Greek debt is pretty astonishing and the demand for the first Greek bond issue has outstripped even the most optimistic forecasts. As the newswires pointed out this morning, it increased quite significantly overnight:

But this outcome has left a few people scratching their heads and wondering what this means for Greece and the eurozone – both of which continue to struggle when judged on a broader set of data indicators. Below, we try to address some of these questions in a reader-friendly Q&A.

Why has demand been so strong?

There are a couple of reasons for this, and they have little to do with Greece.

• The bond auction remains small, and the yield fairly decent relative to other peripheral economies and 'junk' or high yield bonds of similar length. And there will always be investors looking for a better return. After all, even in the immediate aftermath of the Greek debt restructuring there were plenty of investors willing to take a punt on the newly formed bonds in the secondary market – and many of them ended up with good returns.
• This links to a broader problem in Europe, and even in developed economies – the shortage of safe assets and the lack of yield. Given the rock-bottom interest rates and dwindling inflation, the level of return available on many financial instruments is not what it used to be, and investors are keen to find new avenues to boost their gains.

But isn’t there a huge amount of risk involved?

Actually, given the structure of the deal and the environment involved, maybe not as much as one would expect (click on the graph to enlarge).

• Firstly, the bonds will be issued under English law. This will stop them being restructured in a similar fashion to the previous Greek bonds, meaning that the investors have significantly stronger legal protection.
• Secondly, the maturity of the debt is quite short, especially relative to the very long term (20+ years) maturity on the loans from the eurozone. This ensures that payment of these bonds falls well before Greece needs to start paying off its official loans – as the graph above highlights.
• Thirdly, the ECB’s promise to purchase government bonds if the crisis escalates again still stands. Furthermore, this has been combined with greater support from the eurozone for Greece and a new aversion to write downs of sovereign debt. 
• All of this means the likelihood of losses on Greek private sector debt has been significantly reduced. It has not been eliminated, but if any write-down were to be forthcoming it would most likely be losses on official sector loans, not least because they now make up 66% of Greek debt.

This has almost come out of nowhere in the past week or two: why such a rush?

• The first, obvious reason is Greece’s need for further funding. The issue of a funding gap this year and over the coming years (estimated to be around €20bn up to 2016) has been well covered. This bond issue, combined with some new fiscal measures and probably the leftover capital in the Greek bank bailout fund, will help fill most of that fiscal gap over the next couple of years. It also potentially paves the way for further debt issues.
• However, there are deeper political reasons. As shown by yesterday’s anti-austerity strikes, this morning's bombing outside the Bank of Greece and the dwindling majority of the government in parliament (which now stands at only two seats), there still is a significant amount of political uncertainty around. The government seems to harbour hopes that this return to the markets will galvanise its support, and act as a symbol of the turnaround it has helped to create.
• Furthermore, with the European elections around the corner and the opposition SYRIZA party looking set to do well, the government seems to believe that this issue could somewhat also boost their support at the polls.

But how much of a turnaround does this really signify for Greece?

While it’s certainly a positive, the macro level data for Greece remains worrying. As the charts below show (courtesy of Natixis), unemployment remains very high. In particular, youth and long-term unemployment are both stubbornly high, and threaten to become a drag on the economy in the longer term. While business activity has stopped its decline, the hope of a swift recovery is yet to be based on clear evidence. There is a long way to go in the structural reform programme, as highlighted by the 329 reforms recommended by the OECD.

More broadly, Greece’s long term strategy for competing and growing in the eurozone remains unclear, and it has zero room to absorb further economic shocks. Citi - forever bearish on Greece - took it upon themselves to be the buzzkill amongst all this optimisim with the chart below (via FT Alphaville). Ultimately, it remains a small symbolic step, especially given the size of the bond issue.

 Will Greece get to spend this money as it wishes?

That seems hopeful at best. While Greece may have a little more flexibility compared to when the funding comes from official loans, of which almost every penny is clearly assigned, there will be little wiggle room. As even those countries outside bailout programmes have found, the oversight at the eurozone level is now quite significant. Greece’s budget still has to be agreed in tandem with the EU/IMF/ECB Troika, and little flexibility is likely to be allowed, especially since there is already an outstanding funding gap which needs to be filled.

The FTT is dying a death of a thousand cuts – this could be the final one

The EU’s Financial Transaction Tax has taken another big blow today – possibly a fatal one.

A leaked legal opinion by the European Council’s legal service has warned that the current set up of the FTT pursued by 11 member states “infringes” on and “is not compatible” with the current EU treaties (the FT’s Brussels blog has posted the full text and done a good round up of the issues at play).

The legal service was asked to look specifically into whether the FTT’s counterparty principle (taxation based on where the counterparty of the transaction is based) infringed on the right of member states which are not taking part in enhanced cooperation policy not to be affected by said policy (Article 327 TFEU).

The criticism is very much in line with complaints raised by the UK as well as by previous leaked documents (which we exclusively published) which showed growing concerns over the extraterritoriality of the FTT and that it may be discriminatory against non-participating members:

“Concerning the deemed establishment based on the counterparty principle, raises issues of extraterritorial exercise of jurisdiction, disrespect of non-participating Member States' rights under the Treaty, and compatibility with the principles of free movement of capital and non-discrimination.”

“[The counterparty principle] would constitute the exercise of jurisdiction over entities located outside the geographical area concerned by the legislation adopted under the enhanced cooperation.”

“The FTT proposed will be levied not only on risky activities but to a large extent also on activities with a genuine economic substance that are not liable to contribute to systemic risk and which are indispensable for the activities of non-financial business entities. Where activities are covered that can indeed be considered to be liable to contribute to financial markets' risk, it has not been demonstrated that the interests of Member States' are endangered to a point that the Union should divert from its attitude in principle of restraint as to extraterritorial exercise of jurisdiction.”

Those are just a few of the very clear and strongly worded arguments put forth by the legal service. Given the clarity and depth of the arguments presented it is hard not to see this as the final nail in the coffin for this (much maligned) proposal for the FTT.

Given the politics of this, there will have to be some form of 'financial transaction tax'. But, this is now likely to amount to a significantly watered down tax, possibly focused solely on equities and levied at a much lower rate only on those specifically trading the products (similar to the UK's stamp duty).

In any case, this is a big win for the UK – although how much credit it can take for it is unclear. In the end the combination of legal overstretch as well as the potential to inflict significant financial damage on fragile eurozone states has undermined the FTT. Equally this is a blow to the Commission and the European Parliament which have pushed hard and invested a lot of time resources into getting this version of the FTT through.

That said, the Commission has remained unsurprisingly steadfast, suggesting that it rejects the legal opinion and believes the current set up is compatible with the EU treaties. The German government has also suggested it will continue to pursue the FTT, but has said that it will seek to iron out all legal uncertainties first (though some in Germany have previously raised concerns about the substance of tax).

Ultimately, this may have to be decided in court. But the case for the FTT has certainly taken another hefty blow.

The EU wades into the murky world of shadow banking

The European Commission this morning unveiled its initial proposals to regulate ‘shadow banking’ and money market funds (MMFs) – the press release is here and the FAQs are here and here.

We covered this issue back in May when we exclusively released the initial drafts of the proposals – not too much has changed since then. We’ll refrain from recapping the details since the press releases lay them out but below we outline some of our thoughts.

• The key point in the regulation is that MMFs will be required to hold a ‘Net Asset Value’ Buffer, equal to 3% of all assets under management; the Commission predicts this will “result in an increase of the management fees of 0.09% to 0.30% annually”. There will also be harmonisation with UCITS and AIFMD to move towards a uniform set of rules for the shadow banking sector.

• As we noted before, the required buffer has real potential to harm the MMF industry. Given the record low interest rates, and very low returns on liquid short term debt, many funds are struggling to stay afloat (with some already shutting down). Although an outcry against increased costs may be expected from the industry, in this case many of the concerns seem valid given the very small margins involved in these funds.

• There are also some requirements on MMFs holding very liquid assets which can be sold off quickly, while also limiting the level of assets taken from a single issuer to encourage diversification. These rules seem sensible but add further constraints to the returns and flexibility of these funds. There is always a risk in dictating the investment decisions to the market, although its important that the risks in these funds is made clear. It also seems to be doubling up the effort of the buffer mentioned above  - given that losses of such funds rarely exceed 3% (as the Commission itself notes), pushing beyond this level seems slightly redundant.

• The question of ‘sponsors’ – the banks or institutions which own and/or backstop an MMF – is also vital for a couple of reasons. First, its clear that some sponsors have a competitive advantage, larger institutions will have the ability to provide greater financial aid to its MMF if it gets into trouble – this gives large banks a significant advantage over smaller asset managers. Secondly, it also provides another clear link between the shadow and traditional banking sector, this could potentially become an avenue for contagion (as was seen in the financial crisis) if MMFs get into trouble and need to be bailed out.

• Much of the rest of the regulation looks fairly sensible at first glance. It’s clear there needs to be greater transparency within the MMF sector – it can no longer be assumed to be equivalent to bank deposits. There also needs to be significantly less emphasis on external ratings by the credit rating agencies (equally true of the standard banking sector ). Furthermore, investors need to be clearer on the risk taken on when investing in these funds and their approach used to make profit (short term funding of long term assets).

• The broader shadow banking communication remains fairly vague but it is certainly an area which needs to be regulated. The main aim should be to incorporate international regulatory efforts with the existing multitude of EU regulations (many of which cover parts of the shadow banking sector) and avoid duplication. Tackling the issue of ‘collateral chains’ (using a single piece of collateral many times) is also vital, although the importance of the repo market should not be forgotten (see failure of the FTT).

All that said, there is a long way to go in these regulations yet. There is likely to be significant industry opposition (or at least discussion) and approval from both the European Parliament and member states will be tough to gain. It also seems unlikely that this will be completed before next May’s European elections, adding further delays but also raises the question of whether the next Commission will push in the same direction on this issue.

Exclusive: Internal docs give first look at EU plans to regulate 'shadow banking'

The Times reports today on another round of exclusive documents leaked by Open Europe, this time regarding European Commission plans to regulate the ‘shadow banking sector’. See here and here for the docs.

A rather niche story you might think but it could have important implications for the way money is lent throughout the economy. Below we provide some background and our thoughts on the proposals.

What is the shadow banking sector?

“The FSB defined the shadow banking system as "the system of credit intermediation that involves entities and activities outside the regular banking system". This definition implies the shadow banking system is based on two intertwined pillars.

First, entities operating outside the regular banking system engaged in one of the following activities:

• accepting funding with deposit-like characteristics;
• performing maturity and/or liquidity transformation;
• undergoing credit risk transfer; and,
• using direct or indirect financial leverage.

Second, activities that could act as important sources of funding of non-bank entities. These activities include securitisation, securities lending and repurchase transactions ("repo").”

Essentially, it is made up of institutions outside the banking sector but which provide paths for borrowing and lending as well as significant financial investments. According to the Financial Stability Board (FSB) in 2011 it totalled €51 trillion worldwide.

Why are there concerns regarding it and are they valid?

• Shadow banking came to light in the aftermath of the financial crisis where it is thought to have played an important role in allowing the financial sector to hide the true level of risk in the system.
• There are some valid concerns over shadow banking. It operates outside but closely related to and interlinked with the regular banking system. This means it falls outside of scope of regular supervision and regulation.
• Often pursue highly leveraged activities, search for high yields and transform maturities from short to long (can cause a mismatch in funding if a crisis hits). There is significant use of opaque securitisation, hard to judge real value.
• Often have very low levels of capital, funded in the short term by lending and investments which needs to be regularly rolled over. This is used to fund long term assets. Helps boost profits but also magnifies losses. Due to this set up, the system very exposed to liquidity crises which can hit hard and fast.
• IMF recommended recently that key aims should be to reduce spill over from shadow banking to regular banking system (reduce prospects for rapid contagion in a crisis) and to reduce the procyclicatlity of the shadow system.
• All that said, it does provide a valuable service in many cases, particularly as an alternative method for distributing credit to the real economy when the banking sector is failing to do so sufficiently.

Thoughts on the EU proposals so far

• The proposals are still at an early stage and subject to change. A key issue is how any shadow banking regulation will fit with the raft of other financial regulation in the pipeline or already in force – AIFMD, CRD IV, EMIR, UCITS, and Solvency II to name but a few.
• Importantly, many of these other regulations already cover many of the institutions involved in the shadow banking sector. Avoiding double regulation and inefficiency is vital, therefore judging and implementing the current regulations is important before a shadow bank regulation is brought in.
• Shadow banking is not part of regular market and those involved do not have deposits so there is no question of a government backstop or bailout scenario. Can and should go bust. The main point is that any shadow banking crisis should not transform into a ‘systemic crisis’. The approach should therefore be ‘macroprudential’, taking an overview of the market and ensuring it is not overly risky and/or that it is not too heavily intertwined with regular banking sector.
• This may be more effectively done by setting out guidelines for supervision and cross border data collection that a strict regulation.
• The EU must also be wary of regulating against specific financial instruments, which could have perverse effects. For example, ‘securitisation’ has become a hot topic. This tool was misused during the financial crisis but is not an inherently bad thing. As ECB President Mario Draghi pointed out recently, effective securitisation of SME loans could help boost lending to SMEs and increase level of quality assets in Europe.
• Money Market Funds are different to many other parts of this sector. They are essentially pools of deposits or excess funds from finanical firms which are invested in the short term to gain small gains above what standard deposits would reap. They invest heavily in short term government, corporate and finanical debt and play a key role in providing liquidity to the market. The Commission looks to be regulating these separately, which is the right way to go. However, any small increase in costs could hamper the whole industry since their margins are so low - in fact some have already been closed due to the record low interest rates. 

As we said the proposals are just getting going so all this is still open. Regulation of the shadow banking sector is necessary but its also vital to note that it plays an important role in providing credit to the real economy (despite its rather ominous sounding name). At this point in time its not clear that a regulation is needed immediately and it may be more effective to improve and work with what is currently on the table. Furthermore, in an ideal world, any attempt to tackle it would be done on a global level in the form of a set of guidelines and plans for data sharing and increased transparency.

A marginal impact of the ECB rate cut?

As expected the ECB announced it has cut its main interest rate by 0.25% to 0.5%. As we noted at length, this is likely to have little impact on the real economy. The real question remains whether it will announce any additional non-standard measures to help boost lending in the economy – see here for our discussion of the many constraints on such action.

Slightly more interestingly the ECB cut its marginal lending facility rate by 0.5% to 1% (this is the overnight lending facility which the ECB provides, but is often used as a last resort since borrowing on the markets should be cheaper except in an emergency). This may have just been procedural to keep the corridor between the main rate and this rate at a standard size. The graph below (in €m) highlights that borrowing under marginal lending facility is at near record lows:

This could mean one of two things. Either:

• No-one has much use for the marginal facility given the unlimited liquidity provided under normal ECB operations and the much more placid market sentiment seen at the moment.
• Alternatively, it could be that the rate has been too punitive to make its use worthwhile at this point in time, even if banks are struggling for liquidity. The lack of overnight repo market lending suggests this may be the case to some extent, although clearly banks have significant liquidity so may just be doing a better job of managing their needs.

If it is the first point (as we suspect) then it is unlikely to make much difference since no-one is using the facility anyway (similar to the main refinancing rate and the limited impact of its cut). @LorcanRK also notes that the marginal lending rate can provide a reference for Emergency Liquidty Assistance which is still used heavily in certain countries, notably Cyprus and Greece. Reducing this rate provides some relief for them.

In any case, all of this is unlikely to have much impact, the tone of the ECB press conference and any further specifics announced will be far more important.

When ideology meets economic reality (Part II): Bundesbank says EU financial transaction tax could make banks more reliant on cheap ECB money

As was made evident by the internal memo about the EU financial transaction tax (FTT) - that we exclusively published yesterday - there are plenty of concerns amongst the supposed champions of the idea.

Today, another heavyweight institution raised the alarm: Die Bundesbank.

This could come across as a niche issue, as with most central banking issues. But as with most central banking issues it could also be of vital political importance in Germany.

As we noted in our flash analysis on the UK’s FTT challenge last Friday, the proposal could have a worrying impact on ECB monetary policy:

Increasing banks’ reliance on cheap ECB cash: With central bank lending exempt from the FTT but the market channels to obtain liquidity hit hard, the FTT actually provides a perverse incentive for banks to borrow cheap money from the ECB and central banks. This runs completely contrary to efforts in the Eurozone to get banks off ECB liquidity and could instead further entrench market fragmentation.

This is a point which has been rarely made in the FTT debate but whose implications for Germany - already deeply worried about weak banks over-reliance on cheap ECB funding - could be huge. Sure enough, Bundesbank President Jens Weidmann today raised concerns over this very issue. In a speech in Dresden, he said:

The introduction of the tax has basically been decided but the unintended side effects could be considerable: In its currently envisaged form, the tax will cover asset-backed money market funds, so-called repo firms, and significantly damage the repo market. However, the repo market has a central role in ensuring the equalisation of liquidity between commercial banks.

If it does not function correctly, the corresponding institutions are diverted onto the Eurosystem, and the Central Banks remain massively and permanently involved in the liquidity equalisation between the Banks.

From a monetary policy perspective, the financial transactions tax in its current form is therefore to be viewed very critically, and it shows how important it is to precisely test a regulatory scheme before its introduction. This however takes a bit of time.

Exactly as we warned. More banks - particularly in the southern eurozone - borrowing from the ECB would not only increase German exposure to the crisis (ultimately, the ECB is taxpayer-backed). But it also negatively impacts the independence of ECB monetary policy since it will hamper the central bank's ability to exit its abnormal liquidity operations and therefore impact its ability to control policy.

This also gets to the heart of what we (and others) have been saying about the FTT.  Although the headline goals and figures look nice, the multitude of side effects (for financial markets, for pensions and even for central banks) mean the real impact of the FTT is far beyond what is envisaged or what can be effectively managed by the regulation.

Watch this space. This could become a big issue in Germany.

EXCLUSIVE: Internal documents reveal countries' concerns with FTT proposal (or when ideology meets economic reality)

The European Commission, of course, doesn't get what the fuss is about, but some countries that are meant to participate in the much-criticised EU financial transaction tax now seem to be going very cold on the idea. Or at least on the way the tax is drafted at the moment.

We have got our hands on the memo from the eleven countries that under "enhanced cooperation" have signed up to the tax - reported in yesterday's press summary - which raises a series of concerns about the Commission's draft. Exclusively, we today publish the full six-page memo here.

The memo, which in painful EU-jargon is known as a "non-paper", was last week discussed amongst civil servants from EU member states, at a meeting behind behind closed doors. So this isn't reflecting any final position on behalf of the eleven (who disagree amongst themselves on a number of issues). 

However, this is revealing stuff - it's clear that though several countries are supportive of the FTT in public, they have a whole host of concerns in private.  The document is desperately looking for answers on how the Tobin tax would work in practice. This is, of course, in addition to the more fundamental objections to the FTT raised by the UK's ECJ legal challenge, now also supported by Luxembourg, which we have analysed here.

You can read the whole thing here, but the key points that struck us are outlined below:

• There are calls to clarify how collection of revenues would work in practice.

• The countries complain that the European Commission’s impact assessment “is not fully clear on how the taxation on government bonds would interact with the cost of national debt” and whether an increase in the cost “could be counterbalanced by the revenues of the FTT.”

• In addition, there are concerns about the impact on repurchase operations on sovereign bonds. "The tax will induce an additional cost that is not sustainable for the market participants,” according to the document. “Repo operations are very useful for managing the treasury liquidity, and the disappearance of this market combined with the lack of viable alternatives will induce serious problems about risk management.” Ever so worried about skyrocketing government borrowing costs, Italy seems particularly worried about this.

• Given the way ‘territoriality’ works under the Commission proposal in particular, each member state would not be allowed “to collect the whole EU FTT paid on the bonds issued by the same member state. As a result, the increase of cost of government debt…would not necessarily be compensated by the collection of the tax on the same instruments.” This sort of links to UK concerns that the tax would hit a firm based in one country, but be collected by (and therefore the revenue will be enjoyed by) a government in another. Taxation without representation some would say.

• The rate levied is also an issue: “The 0.1% uniform tax rate proposed by the Commission might create an inappropriate burden on short-term bonds…compared to long-term bonds.”

• And the concerns are not only limited to government bonds. The countries note that, “Businesses have expressed worries that the same effect described above for government bonds would replicate on the corporate issuers, with negative effects on the financing capability of companies.” As we've argued repeatedly, this is the risk that the tax will hit business at a time when these are already struggling to balance their books (and are facing particularly high borrowing costs in the south).

• Uncertainty over the impact of the FTT on high-frequency trading.

• The member states also ask the Commission to clarify a number of definitions in its proposal (e.g. ‘purchase and sale of a financial instrument’, ‘cancellation or rectification of a financial transaction’, and so forth).

In other words, even among its supposed champions, the potential impact and practicality of the FTT are shrouded in uncertainty and a lot of concerns, particularly when it comes to effects on the real economy at a time when the eurozone is desperate looking for growth.

For anyone with an ounce of grasp of economics, this internal memo strongly supports the accusation that the FTT has a lot more to do with politics than evidence-based policy.

When ideology meets economic reality.

Game on - UK Government launches legal challenge against controversial EU Financial Transaction Tax

It has just been announced that at midnight last night the UK government submitted a challenge against the financial transaction tax to the European Court of Justice. The ground being that it impacts (taxes) firms and individuals located in the UK outside the FTT zone.

We’ve put together a very comprehensive analysis on what this challenge means and what could happen next. Read it here.

Here’s the summary of the key points:

Summary: The UK has today announced a legal challenge at the European Court of Justice against the EU’s controversial financial transaction tax (FTT). Despite the British Government having chosen not to participate in the measure, UK financial firms that trade with an institution in a country that does participate will still be taxed. This, the UK claims, violates EU law and is inconsistent with international tax norms.

The economic, legal and political implications of this move for future EU-UK relations are huge. As currently drafted, the tax could cost fund managers (UCITS) based outside the FTT-zone around €5.6bn while one third of all derivatives trades in the UK could be caught by the tax. Legally, it could set out the parameters for how a “flexible Europe” involving different levels of participation in the EU – which Prime Minister David Cameron has said he champions – will be governed. Politically, it’s a test of the extent to which the UK – as a non-eurozone member - can halt or change EU measures with a profound impact on its national interest. Therefore, it will be a key issue in the on-going debate about the UK’s continued EU membership, though other EU countries have also expressed concerns about the impact of the tax.

You want contagion…I’ll show you contagion…

Everyone, including us, has commented at some point this week about how calmly markets have reacted to the situation in Cyprus.

Cue Dutch Finance Minister Jeroen Dijsselbloem.

From his interview with Reuters:

"What we've done last night is what I call pushing back the risks…If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?'… If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders."

"If we want to have a healthy, sound financial sector, the only way is to say, 'Look, there where you take on the risks, you must deal with them, and if you can't deal with them, then you shouldn't have taken them on’”.

"The consequences may be that it's the end of story, and that is an approach that I think, now that we are out of the heat of the crisis, we should take."

"We should aim at a situation where we will never need to even consider direct recapitalisation…If we have even more instruments in terms of bail-in and how far we can go on bail-in, the need for direct recap will become smaller and smaller.”

"Now we're going down the bail-in track and I'm pretty confident that the markets will see this as a sensible, very concentrated and direct approach instead of a more general approach".

We’ve bolded the key quote. Essentially, he saying the Cyprus deal might be a template for other bank restructurings across the eurozone (although he seems to be trying to row back from this a bit).

Now, we’re not saying we disagree with his points and we certainly agree with the sentiment of his comments – banks should be able to shoulder their own risks and if they can’t they should have plans for winding down and deleveraging. This is why we’ve long argued for things such as living wills for banks.

Let’s be clear, banks should be responsible for their own risks. That said, if you go round telling markets all week that Cyprus is unique and specific and all year that a banking union is on its way with an ESM backed recap fund, they aren’t going to take kindly to abruptly finding out otherwise.

It all just seems a bit strange and a bit clumsy - to put it mildly. Sometimes for better or worse, markets need to be handled with kid gloves.

Contrary to his expectation that markets would see it as “sensible”, they have reacted wildly. Spanish and Italian stock markets have swung into negative territory after being up for the day, led by their banks taking a hammering, figures via @suanzes:

Ibex35: -2,68%. BBVA (3.97%), Bankinter (-4%), CaixaBank (-2,44%), Banco Popular (-4.147%), Sabadell (-3,83), Santander (-3,27%)

As we have said before, we never quite bought that Greece, Cyprus or anyone was entirely unique, though with Greece eurozone leaders definitely could have got away with it.

Where does this leave plans for banking union and eurozone integration? We’re hesitant to say tatters, but it’s not looking great.

Some more signs of financial market fragmentation in the eurozone?

The European Repo Council of the International Capital Market Association (ICMA) released its bi-annual assessment of the European repo markets today. Admittedly, not the most exciting of intros but the survey does contain some interesting points regarding financial markets in the eurozone. As a reminder, repo markets are the main source of short term funding for banks (or at least they should be if markets are functioning normally).

The report highlights that repo funding fell by 11.9% during 2012 (based on a standard sample size). Interestingly, the fall slowed significantly in the second half of the year – there was only a 0.9% drop in the market from June to December. This is likely to have been down to the creation of the ECB bond buying programme, OMT.

There are a few other interesting points and conclusions which can be drawn from the report:

• As of the start of this year, European banks remain heavily reliant on ECB funding. The LTRO repayment has shown this has decreased somewhat. However, as we previously noted, if the repo market does not pick up the slack then we could see a de-facto tightening of monetary policy (the opposite of what the ECB is trying to achieve).
•  There is some evidence of an increase in cross border repos up from 48.1% to 50.5%. However, importantly, cross border repos between eurozone only countries remained steady – suggesting significant market fragmentation remains in the eurozone.
• The share of transactions which we were for a maturity of a year or more dropped from 13.3% in June to 5.9% in December, suggesting banks filled much of their long term financing needs at the ECB LTRO. This will be an interesting indicator to watch in the next survey to judge the impact of LTRO repayments.
• The ICMA also go to lengths to highlight the threat of the financial transaction tax (FTT) to the repo markets.
• Government bonds, especially from core eurozone countries, remained a key source of collateral for repo transactions. In fact, the use of German government bonds as collateral increased sharply. Usually, this would be seen as a sign of risk aversion and a flight to safety (i.e. negative for the prospect of recovery), however, ICMA suggests this is actually a positive sign since previously these bonds were being hoarded to improve balance sheet safety. Still, the over-reliance on core government bond highlights the shortage of safe assets in the eurozone and should be taken into account when considering why borrowing costs have remain low despite increased tensions in the eurozone once again.

Overall the survey seems to confirm fears that fragmentation remains in the eurozone financial markets, as does over-reliance on the ECB - at least up to the end of 2012. The real question is whether this has been reversed at all at the start of this year. Unfortunately, we’ll have to wait until the September survey for a conclusive answer on that point.

Another tricky morning for the eurozone

It’s been a somewhat less than pleasant morning for the eurozone. Firstly, the European Commission put out its latest economic growth forecasts, which do not make great reading for many countries. Here is a comparison between the EC's forecasts and the latest national government forecasts for growth:

As the table shows, there is a long list of countries which seem to be overestimating their growth for this year including: Italy, France, Spain, the Netherlands and Ireland.

We expect to see a series of growth revisions throughout the year on the part of national governments – in some cases such as Greece, we expect that the Commission forecasts will also prove overly optimistic (notably the figures used in the Greek budget are actually below the Commission forecasts). The figures also highlight the growing cracks in the Franco-German axis as the two countries diverge economically; this was reinforced by the starkly different PMI (business activity) figures yesterday.

The implications of these inflated growth projections are also becoming apparent. Nowhere is this clearer than in Spain, where the Commission highlights that, without additional measures, the Spanish government deficit in 2013 and 2014 will be 6.7% and 7.2% of GDP respectively. This compares to targets laid down by the eurozone of 4.5% and 2.8% respectively.

The Commission’s estimates of Greek unemployment also still seem unrealistic, at 27% and 25.7% in 2013 and 2014. In November 2012 unemployment reached 27% in Greece, according to the Greek statistics agency. With plenty of structural reforms still to go we expect this figure to increase further.

Secondly, the announcement of the repayment of the ECB’s second Long Term Refinancing Operation (LTRO) came in significantly lower than expected – 356 banks repaid €61.1bn compared to average expectations of €122.5bn. The steep slide in the euro exemplified the market response.

This highlights that underneath the recent optimism there is still significant fragmentation in financial markets and concerns over liquidity (as we have noted previously). Although impossible to tell conclusively, since these are just aggregate figures, we expect that many of the banks that have repaid were from ‘core’ eurozone countries, further exacerbating the differences between eurozone countries.

If you are looking for a silver lining, it could be that the rise in the euro has been halted for now, which may aid the competitiveness of the weaker countries, and that a potential de facto tightening of monetary policy has been avoided - this could have been a concern if banks repaid the LTRO and deleveraged rather than investing the collateral elsewhere.

The picture emerging from this morning’s data, then, continues to be a bleak one for the eurozone thanks to stalling growth across the bloc and banks hanging onto ECB liquidity. Beyond the headlines though, there is evidence of growing divisions as some of the core countries post growth and their banks repay ECB funding while peripheral countries find themselves in economic decline with banks surviving on ECB money but lending little.

Another positive step for Ireland?

Well we finally have a deal on one of the longest running sagas in the eurozone crisis – the Irish promissory notes deal.

See here for some good background on the whole issue.

Key points of the deal (from Irish PM Enda Kenny’s speech):

·         Last night the Irish Bank Resolution Corporation (IBRC, formerly Anglo Irish bank) was liquidated. The loans it had taken from the ECB through the Emergency Liquidity Assistance (ELA) were therefore terminated and the Irish Central Bank (ICB) took control of the €25bn in promissory notes and the €3.4bn for the most recent interest/principal payment.

·         The Irish government has agreed to swap these notes for 40 year Irish government bonds.

·         The principal repayments will take place between 2038 and 2053. The average interest rate will be 3% compared to 8% on the promissory note.

·         The Irish National Treasury Management Agency (NTMA, which owns NAMA and formerly IBRC) will see its borrowing requirement over the next decade fall by €20bn. The Irish government deficit will be reduced by approximately €1bn a year.

Essentially then, the IBRC was wound down, allowing/forcing the ICB to take control of the promissory notes which were used as collateral for the ELA which it had been providing, in turn allowing the IBRC to continue servicing its bondholders, depositors and any other obligations. It was then agreed to swap these notes for the longer dated lower interest ones.

It seems to be a fairly reasonable idea and a good work-around of a tricky situation. It certainly provides a reduction in the burden with a much lower interest payment and no principal payment for some time.

The main ECB concerns were: monetary financing if the collateral was allowed to be swapped for lower value (longer dated collateral), the further write-down of bondholders and setting a bad precedent for other eurozone members. Most of these have been addressed, although there are a few issues outstanding:

The first issue was mainly a concern while IRBC existed. That said, if the ICB took control of the bonds when the ELA was terminated as the IBRC was liquidated, why were they suddenly willing to exchange them for the new bonds? Surely, these longer dated lower interest bonds have a lower net present value than the previous promissory notes? This may be because the ICB and the Eurosystem tend to hold such assets at nominal value, but it’s hard to argue that the ICB hasn’t taken a loss in some terms.

The second seems to have been dodged as the remaining liabilities will be covered by the Deposit Guarantee Scheme and Eligible Liabilities Guarantee Scheme (see FT Alphaville here for more details) and transferred to NAMA. That said, the role of NAMA now that the ELA has been terminated isn’t clear. Will it still finance these liabilities, if so, how? Surely, it would need to use the new bonds to borrow from the ECB to finance the remaining IBRC liabilities. This isn’t an issue as such, but needs clarification since it impacts: who is holding the new bonds, what interest is being paid and who it is paid to.

On the third issue, the ECB seems to accepted that this is a fairly special case and that setting a precedent is not much of a concern – or is at least less of a concern than the consequences of not giving Ireland a deal on the promissory notes.

A few remaining issues then, but nothing major and no deal breakers – although the monetary financing issue could potentially flare up in our view.

Ultimately, some deal was needed on this front both to reduce the impact of financing the Irish bank bailout on the Irish budget and to maintain political support for the extensive reform programme being undertaken in Ireland. Another positive step in the recovery of the Irish economy it seems. That said, the deal does not succeed in significantly reducing the overall cost of the Anglo Irish Bank bailout and the cost of the bank bailout will continue to weigh on Irish debt - i.e. plenty of challenges remain.

The FTT debate rumbles on...

The FT reported today on the latest draft proposals for the EU financial transactions tax (FTT), which is proceeding under enhanced cooperation with 11 countries taking part. These are the highlights from the FT's report (since we are yet to get our hands on the draft proposal):

• The FTT is expected to raise up to €35bn.
• It will apply to any share, bond or derivative issued within the participating area or "with a clear connection to a participating member state" in an attempt to restrict relocation to avoid the tax.
• Target introduction date of January 2014.

Although the basic structure is the same, the most potentially controversial element is the extension of the scope of the FTT to apply to any share, bond or derivative "with a clear connection to a participating member state." This means that financial instruments which are traded outside of the participating countries could still be caught by the tax. This throws up a number of important questions and potential problems:

• This could ultimately result in participating governments imposing taxes within other government’s jurisdictions. This goes further than just other EU countries.
• It is not clear to where the revenue would flow (to the government where the trade is located or back to the FTT participants?) or how it would be enforced at a global or EU level. (This also seems to add massively to the complexity, a reduction of which is a cited benefit of the FTT).
• Surely, there are questions regarding how this cuts across the single market. As the press release on enhanced cooperation notes, the FTT will “respect the rights, competences and obligations of non-participating Member States” – stepping on the rights of non-participating government to determine which taxes are applied in their sovereign territory does not seem to fit this description. Some of the non-participating members could certainly be unpleasantly surprised and may well have some complaints to lodge.
• The new clause (to stop capital from flowing outside the FTT zone) seems to go against the key EU principle of free movement of capital in spirit, if not in law.
• For those involved, the tax will likely have some impact on their borrowing costs (for both governments and firms based in these countries). It will also increase the cost of instruments used to hedge against risk in these countries (certain derivatives). This may not be massive but will come at a time when it is not needed.

We do not know what form the final proposal will take but, if the reports are accurate, this FTT could not only pose practical difficulties of enforcement but also cut across the single market.

Update - 18:07 30/01/13:
 The FT has flagged up to us that, under latest proposal, the rules will only apply to exchange traded derivatives rather than all (over the counter) derivatives. This certainly makes the collection and policing of the tax easier and may limit any distortion on derivatives market somewhat. We'd note though that the general enforcement of the tax across borders and particularly outside the EU will remain tricky.

A vote of confidence? Banks start repaying ECB long term loans

This morning saw the start of the on-going process of repayments of the loans given by the ECB to European banks under the Long Term Refinancing Operation (LTRO) (see here for details).

The ECB announced that 278 banks have already pledged to repay €137.2bn. This compared to the 523 banks in total that borrowed around €190bn in net liquidity from the first LTRO at the end of 2011. The amount repaid was above expectations – below we assess why this may have been and what it could mean for the eurozone.

Why have banks decided to repay so much so early?

- A big motivating factor is reputation. It is clear that banks which repay early can highlight that they have access to market funding at low levels and have a sustainable business model.

- Although the loans seem cheap with the low ECB rate they require lots of collateral (to which haircuts are applied). This cost mounts up and some banks (particularly in northern countries) can now borrow on the markets more cheaply. ECB funding is also secured (against the aforementioned collateral) this ties up lots of banks assets, many may prefer to seek unsecured market funding, even if it is a bit more costly.

- Having huge amounts of excess liquidity just parked at the ECB is not efficient or effective. It also distorts bank balance sheets and may detract from other goals such as deleveraging or recapitalisation (more on this in a minute).

What does this mean, if anything, for the eurozone?

- There are fears over a two-tier banking system between those stronger banks funding themselves on the market and those reliant on the ECB. We would add that this furthers the divergence in the eurozone since the split is broadly along the existing strong/weak country divides.

- If the move is to aid banks in deleveraging this could perversely have a negative effect on the eurozone, with banks decreasing lending and reducing demand for euro (particularly peripheral) assets.

- That said the net impact on liquidity is limited, with excess liquidity in the system still at almost €700bn. It may need a further €200bn to be removed before the impact is substantially felt in terms of borrowing costs and demand for assets in the eurozone.

- There could well be a confidence boost from the higher than expected repayment. However, if this furthers a strengthening in the euro there could be growing concerns that it could begin to hamper exports in the weaker economies (a key driver of growth when both public and private sector are limited spending). This also furthers tensions within the one-size-fits-all monetary policy.

So, there are some clear reasons for repaying the loans early, although what it means for the eurozone and the impact it could have is far from clear (this is partly because the actual impact of the LTRO beyond helping banks fund themselves is far from clear). 

One more thing: many analysts are now making a song and dance about the reduction in the size of the ECB balance sheet - seeing it as a great positive. Which it is of course. But strangely, the same people always made the point that the ECB's expanding balance sheet, really wasn't that importance. So which is it?

In any case, as we said at the start, this is a rolling process and the full impact will not be clear for some time. The most important point to watch now is the location of the banks which announce that they have repaid. If it turns out to be solely northern banks, we could see some divergence emerging in the banking system, at just a time when eurozone 'bank union' plans are trying to unify it.

Draghi getting ahead of himself: are we really seeing a “normal situation” in eurozone financial markets?

In his monthly press conference on the 10 January 2013 ECB President Mario Draghi struck a relatively upbeat tone on eurozone, in particular arguing that the eurozone was returning to a “normal situation, from a financial viewpoint”. Don’t get ahead of yourself there, Mario.

True, he also warned against a slowdown in fiscal consolidation and structural reforms due to political complacency, but hinting that we’re now back to a normal finacial market situation seems particularly premature.

Firstly, to state the obvious, the ECB is still massively propping up the financial system in the eurozone. The ECB balance sheet stands at a massive €2.96 trillion up from around €1.5 trillion at the start of 2008. The ECB’s liquidity provision to banks across Europe has slowed in recent months but it remains exorbitantly high, to the point where many banks (particularly in struggling countries) are almost exclusively relying on the ECB for funding. In fact ECB exposure to the PIIGS totalled €1.08 trillion in November 2012. This is by no means normal (or at least shouldn't be).

There is also still significantly limited activity in the interbank lending market, with overnight volumes still near record lows (click graph to enlarge).

Data from the BIS also highlights that longer term bank lending and investment from stronger to weaker states continues to be dramatically below its peak (click to enlarge).

There are many other indicators, such as the limited lending to both businesses and households across the eurozone and the divergence in borrowing costs within different economies (for corporates as well as sovereigns).

Still, the situation in the Eurozone has clearly improved. Some factors, such as the capital outflow from southern to northern countries, have stabilised while others, such as the outflow of deposits from certain banking systems, have shown positive improvement. But we are still miles from being in what many would regard as a “normal situation”.

So when can we expect a “normal situation” to return? Well, with interbank channels having been absent for so long it is hard to expect a rapid turnaround. The ECB is also not expected to exit its massive liquidity provision anytime soon (and even when it does, it will likely be a gradual process), so this will continue to dictate the market. Plenty of other factors (economic growth, unemployment, social stability) also continue to fuel imbalances in the eurozone, so don’t expect cross-border lending or investment in struggling eurozone economies to return to pre-crisis level in the next few months or even years.

This is where the banking union is supposed to come in. However, as we have noted before, the current plans don’t a cross border backstop or a cross border resolution structure for failing banks, for example, so won’t really help in that respect.

Unfortunately, Draghi’s prematurely upbeat comments may have the perverse effect of encouraging the kind of political complacency which he warned about later on in his press conference.