Open Europe publishes Commission regulation which seeks to move Libor oversight to Paris

As the FTT threat wanes (a sizeable victory for the UK we might add) another battle threatens to flare up in the wider debate about financial regulation within the EU – albeit a smaller but still concerning one.

As the FT reported yesterday, there is a regulation in the pipeline in which the Commission proposes significantly stepping up the regulation of benchmark indexes and rates used in financial markets and contracts. In particular though, it proposes moving the supervision of key benchmarks, such as Libor, to the European Securities and Markets Authority (ESMA).

As we did consistently throughout the FTT debate, we have got our hand on, and have exclusively published these latest plans – see here.

What are the key points of the plans?

• The main focus of the regulation is to move the oversight of thousands of benchmarks used in trillions of dollars’ worth of financial contracts and instruments away from self-regulation (or from being unregulated) to being under direct supervision.
• However, importantly, the proposal sees the most important benchmarks, such as Libor and Euribor, being supervised by ESMA since, in the Commission’s view, fractured oversight harms the single market.
• The plan also looks to step up the legal liability involved in the benchmarks (making any manipulation a criminal offence across the board) but also allowing supervisors more control to compel participation in certain benchmarks and allow for consistent oversight.

Open Europe's take on the plans

• First, let’s make it clear that Libor has patently failed and needs to be reworked. Everyone accepts that. However, the UK is currently in the midst of doing just this, following the recommendations of the Wheatley Review earlier this year (which happen to line up closely with those of IOSCO the international body looking into this issue).

• This makes the proposal particularly badly timed. It is ultimately based on an outdated view of Libor which is already under review and beign changed. In fact, if you look at the substance of the UK review and the international recommendations (upon which the Commission based its proposals) they line up fairly closely with the EU plans other than where the control rests.

• The Commission justification for needing an EU regulation on this issue also seems a bit of a stretch to us. Sure, some of these benchmarks are used in the rest of Europe but they are also used all over the world. However, all those involved in Libor will have a presence in London. As is well known, the large majority of European trades which involve many of these benchmarks will also take place in London. Why the oversight should not be focused there is still not clear.

• There is also rightly a significant concern over the rigidity of the Commission proposal. Firstly, the plan to base all submissions off actual transactions seems unrealistic. This issue came up in the initial debate about reworking Libor – ultimately, there are not nearly enough interbank transactions to actually produce the rates for the ten currencies and the 15 different maturities which Libor currently covers.

• Linked to the above point is the concern about the ability to force banks to comply and take on significant legal and regulatory responsibility for their submissions. Ultimately this is a large liability to take on off the back of what is still an estimate.

• This is a very technical subject. It is almost impossible to lay down all the rules and structures for how various benchmarks should be judged. Surely, the approach varies wildly depending on the benchmark and may even change depending on the wider economic and financial circumstance. This raises two concerns: the rigid framework presented may leave substantial grey areas but more importantly a lot of power for setting the technical details will be left up to the Commission, after the political negotiations have finished. As we saw with the bankers bonus’ regulation this can has a very large impact on the scope and practical implementation of the rules.

• It sets a worrying precedent, especially as the ECB is set to take over as the single eurozone supervisor and the potential for eurozone caucusing on this issue increases. As we saw with the regulation over Credit Rating Agencies (CRAs) over the last few years this can be dangerous. The initial drafts of the CRA regulations are quite similar to this one, however, worryingly it has extended and escalated over time. The UK government should look to tackle this issue head on to avoid a similar scenario.

Overall then, although Libor needs to be reworked and better supervised, it’s not clear why this needs to be done at the EU level, particularly when the UK is in the middle of its own reworking. The rigidity of the proposal also raises questions about its practical implementation. At the very most, there could be an EU directive on this issue setting out a broad approach with room for national flexibility. Ideally though, this should be left to individual states where the rules can be drawn by those who are most impacted by them and closer to the stakeholders. This should of course be combined with on-going global cooperation as is already underway.

Thankfully, it seems we are not the only ones with these concerns and some watering down of these rules already looks likely.

More of the same expected from the ECB despite eurozone economic malaise

The ECB holds its monthly meeting tomorrow. Below we look at the main topics of discussion, with the ECB weighing some important decisions.

Could the ECB cut its main interest rate again?

• Possibly. It is certainly considering it. As with last month, growth and inflation have remained subdued, providing further incentive and scope for the ECB to cut rates.
• There has not been a significant downturn on either front however, meaning many do not expect further action.

The ECB is considering a negative deposit rate
Most reports suggest the ECB Governing Council is split on this issue. At the least this means it is unlikely to push ahead with it. We also believe the problems and complications outweigh the benefits. There has been much written about this but below we summarise the key points.

Logic: banks are now charged for holding large excess reserves (deposits) with the ECB, this will hopefully encourage them to make loans on the interbank market and make more loans to the real economy rather than holding the money at the ECB.

In favour:

• Banks and investors look for higher returns and begin lending cross borders again. This aids financial integration and could help tackle other issues such as the large Target 2 imbalances.
• Increases the amount of times money is circulated through the economy (the velocity of money) as lenders try to avoid getting stuck with excess cash. This could in theory help boost inflation and growth.

Against:

• Contrary to prevailing logic it could actually cause a drop in liquidity. As excess reserves become more expensive banks begin repaying loans they have taken from the ECB. All the while they are deleveraging (may even speed it up), causing less money to flow to the real economy.
• Rates could actually rise for a number of reasons. Larger number of weaker banks forced onto the interbank market. Banks may simply look to pass on increased costs to consumers.
• If banks do not pass on costs or deal with them, then profits will be hit – in many cases they are already worryingly low.
• Could increase the flood of money to safe assets, particularly from the core eurozone countries. The return on these would become even more negative, increasing their costliness and driving divergence with the rest of the eurozone.
• The large money market fund industry, which plays an important role for liquidity in bond markets, could struggle to stay afloat since it relies on small positive returns on safe short terms assets (see above points).
• The euro is likely to weaken, this combined with the other effects could cause a large outflow of cash to other parts of the world, exacerbating problems.

What about all the talk of boosting lending to small businesses?
This focuses around the creation of a new market for securitised loans to small businesses. The logic being: banks make these loans, package them together into securities and then sell them on to other banks and investors. There is a clear demand for quality assets which provide a decent return meaning there could be demand for such securities.

However, the ECB has backed away from grand plans on this issue. As we pointed out previously it was always very hesitant about purchasing such securities itself, with the Bundesbank in particular opposed to such action.

More of the same seems likely
With things ticking over the ECB is likely to hold off on any further drastic action at its meeting tomorrow. It will continue to emphasise that monetary policy will remain loose for some time (the concept of forward guidance which it began to adopt last month to some extent). It may also put more flesh on the bones of schemes to work with the European Investment Bank (EIB) to boost lending to small businesses. Some easing of the collateral rules as we predicted last month is also a definite possibility.

As we’ve said before, the ECB continues to look constrained. It does of course have a few more tools, however, they are in many cases quite extreme and have potential side effects. These are best suited to very extreme scenarios (euro break-up) rather than the wider malaise and long term endemic crisis which the eurozone now faces, particularly given that often (as we are now seeing with banking union) any ECB action sparks complacency and inaction on the part of politicians.

When ideology meets economic reality (Part III): Opposition to the FTT grows at the heart of Europe

As we noted recently with the exclusive release of  internal documents on the Financial Transaction Tax (FTT), even amongst those who are championing the proposal, there are a huge number of concerns. Well, those concerns are growing by the week, it seems. The last few days have seen several new interventions. 

First, there is a report from the Deutscher Aktieninstitute (DAI), an organisation representing German listed companies and investors, which warns that the FTT will cost German companies up to €1.5 billion per year. Blue-chip companies, including Siemens and Bayer, say they will face tens of millions of euros of additional cost from the tax due transactions they make to hedge currency and other risks.

What makes this intervention to significant is that we're talking wholesome, exporting German businesses - in the German public mind the very opposite to ‘speculative’ finance. As DAI chief-executive Christine Bortenlaenger put it, the tax is “a direct strike against the export-oriented German economy”.

This comes not long after the important intervention by Bundesbank President Jens Weidmann where he warned, as we did a few days before, that the FTT could impact monetary policy. With the German elections only a few months away, these concerns will be hard to dismiss.

Secondly, the Dutch Central Bank has issued a warning that the tax will cost the Netherlands a minimum of €500m, half of which will be paid by its large pension fund sector. This is all despite the country not taking part in the FTT directly. Dutch Finance Minister Jeroen Dijsselbloem hinted that the country is looking for a change in the way that the tax is structured so that it does not impact those not directly taking part.

Lastly, Financial News notes that MEPs – who have generally been the most stringent defenders of the tax – may be changing their minds somewhat. Over 100 amendments have been submitted to the current FTT proposal in the European Parliament. Changes include exemptions for pension funds and repo markets as well as calls for a more extensive cost benefit analysis of the impact of the tax  (though the EP doesn't have a binding vote on the FTT, it's still politically signifcant).

This cacophony of voices are strengthened by the fact that many of the concerns raised fall on the same points again and again – the impact on repo markets, the cost to pension funds, the knock on costs for retail borrowers and the reduction in lending to the real economy.

As we have long expected, there seems to be a growing feeling that the FTT will need to be watered down or altered in places if it is to come into force and not have a huge negative impact. The populist rhetoric of the tax seems to be finally butting up against the economic and financial realities which many long warned about.

ECB increasingly likely to cut rates but running short of tools to help the eurozone economy

The ECB looks set to cut its main interest rate by 0.25% to 0.5% on Thursday (while keeping the deposit rate at 0% due to concerns about distortionary effects of negative rates).

Why is the ECB considering cutting rates?

• The obvious answer is that the crisis is clearly dragging on and the eurozone economy is struggling. But, that has been true for some time, so why now?
• Economic activity has been particularly bad (see right hand graph below), while forecasts have been continuously downgraded.
• In particular, annual inflation has dropped well below the ECB’s target of 2%, while unemployment has continued to rise (left hand graph below, click to enlarge).

Will it have any impact?

• Not really. On the margin it will help reduce costs for those banks which borrow heavily from the ECB and consumers with variable rate loans and mortgages – but the impact will be very limited.

• The usual mechanism through which a rate cut is transmitted to the market is broken. See for example the overnight lending in the eurozone. It remains at a very low levels. That said, rates are also at record lows. Why is this? Well, most likely because only the strongest banks are borrowing on these markets. For this reason the cut will not filter through to where it’s most needed since lending rates are already completely detached from it and focus more on the risks of the banks involved.

• As has been well documented, rates in the south and the north are also significantly different, particularly in terms of lending to businesses. Clearly, these have also diverged from the current ECB rates which are already incredibly low. Cutting further is unlikely to impact this.

What other tools does the ECB have?

Communication: ECB indicates willingness to keep monetary policy loose and step in to aid markets if needed. This has been used effectively by the Fed.
Probability: High, especially in coordination with rate cut.
Effectiveness: Minimal boost since it is already being pursued to some extent, more to reassure markets.

Easing collateral rules: ECB widens the range of assets which it accepts as collateral in exchange for its loans. May also decrease the 'haircut' applied to the value of the loans (thereby increasing their worth as collateral). This is likely to be targeted on SME loans and securities made up of SME loans.
Probability: High, if not this month then in June, particularly if economic data continues to be poor. Effectiveness: Limited, could help bank funding but unlikely to boost SME lending significantly. More risk taken onto ECB balance sheet, likely to widen divisions with Bundesbank. Has been done previously and had little impact.

Outright purchases of SME loans and securities: ECB purchases securities of bundled SME loans, similar to the purchases it made under the Covered Bond Purchase Programme and the Securities Markets Programme.
Probability: Very low. Draghi has previously suggested he sees it more as the job of institutions such as the EIB to help SMEs. Furthermore, the level of SME ABS is limited since they rely heavily on bank loans for funding (another reason why the ECB believes a rate cut could help, at least in theory).
Effectiveness: Limited, especially given that the market for such products is not huge. It would also increase the risk taken directly onto the ECB balance sheet (more so than easing collateral) and would provoke an outcry in Germany for overstepping the acceptable level of central bank intervention. Furthermore, such direct purchases are much harder to unwind than loan related policies which expire naturally, selling off these assets will be tough.

A version of the UK 'Funding for Lending' scheme: not really an option for the ECB at this time, contrary to popular belief. The various national regulations and structures aside it is practically impossible since the ECB already applies full allotment (unlimited lending).
Probability: Very low.
Effectiveness: Potentially counterproductive as the ECB would need to end its programme of full allotment in order to then make liquidity dependent on the amount of loans made by banks.

These are to name but a few options being reviewed currently. Other options such as working with the European Investment Bank to promote SME lending would need political assistance, while options such as 'Quantative Easing' aren't viable for the ECB, as we discussed here.

So for all the talk of the rate cut, it will likely have a very minimal impact. The ECB could look to combine it with other policies but the painful reality is that, when it comes to boost lending to the real economy, the ECB has very few options. Constraints from the Bundesbank and concerns over the progression to banking union mean the ECB will likely continue to put the onus on governments to make reforms to boos the economy.

Conflict of interest (rates): clamour for ECB rate cut grows but Germany remains wary

The last few days have seen a shifting of consensus in the ECB rate cuts debate.

Recent economic data in the eurozone has been particularly bad, with private sector activity slowing more than expected. However, potentially more importantly, this effect has been seen in Germany and some of the stronger northern countries as well.

In response to this data most banks and analysts shifted their expectations and now forecast an ECB rate cut in May or June.

The thinking goes that, a slowing economy in these countries (and therefore lower inflation) will give the ECB more scope to cut rates without fear of it having disproportionate effects on the stronger economies. After all, the ECB is meant to find a balance that suits all countries (although it rarely does, hence the flaw of one-size-fits-all monetary policy).

As always on central banking issues though, Germany remains the key player.

German Chancellor Angela Merkel has now waded in to debate about possible ECB action. Speaking at the conference organised by Sparkassen association this morning, Merkel said:

"The ECB is obviously in a difficult position. For Germany it would actually have to raise rates slightly at the moment, but for other countries it would have to do even more for more liquidity to be made available and especially for liquidity to reach corporate financing."

"If we want to get back to a bearable interest rate level, then we have to get over this internal division of the euro zone."

In a country where central bank independence is worshiped, politicians usually stay well clear of commentating on monetary policy, so Merkel's comments are quite extraordinary. Perhaps they were prompted by increasing noise coming out of the French government over what it sees as the need for the ECB to take a more activist approach, despite a genetlemen's agreement between the two governments not to discuss ECB policy in public.

German ECB board member Joerg Asmussen also weighed in yesterday saying:

"Monetary policy is not an all-purpose weapon for any kind of economic illness…Due to impaired monetary policy transmission, the pass-through of rate cuts to the periphery would be limited, and this is where they are most needed.

At the same time, rate cuts would further relax already unprecedentedly easy financing conditions in the core. This is not per se a problem – but interest rates that are too low for too long can eventually lead to distortions. In particular:

• to a misallocation of resources, which ultimately leads to lower potential growth,
• to excessive capital inflows into a number of emerging economies with exchange rate effects and credit risks,
• and to reduced incentives for governments, banks, and corporates to adjust."

For numerous reasons, it seems that a rate cut should not be taken for granted after all. Asmussen is  right that given the broken transmission mechanism and market fragmentation, any cut will have limited effect on the economies where it's meant to provide a boost. But more importantly, there is still a view in Germany that lower rates could have a harmful effect particularly by pumping up an asset and property bubble – similar to those seen when newly low ECB rates were introduced in the south during the euro's creation.

That said, the wave of voices calling for some ECB action is growing, particularly given the wider debate on austerity. It will be tricky to balance this with the demands of the northern countries.

Once again the ECB finds itself stuck as the main player in an increasingly political debate.

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.

Celebrating the end of the eurozone affair ignores the heart of the matter

In today's Telegraph, Mats Persson seeks to answer this simple - and yet brutally complex - question: is the eurozone crisis over?

'We are in the middle of the beginning of the end. The crisis has really hit its peak”, former French economy minister and current IMF chief Christine Lagarde told a broadcaster when asked about the eurozone crisis. The only problem: that was in July 2010. Time and again, EU leaders have declared the crisis over – and been proven wrong. So with markets remaining cautiously optimistic about the euro, is the worst finally behind us?

There are well-rehearsed reasons to be cheerful. Borrowing costs are down for all crisis-stricken countries, exports are picking up in some and EU leaders have actually agreed on a forward-looking measure by turning the ECB into a single supervisor for eurozone banks. Just as eurozone leaders have celebrated prematurely, Anglo-Saxon analysts have consistently tended to overstate the immediate risk of a eurozone break-up. Famously, one major US bank last year assigned an 80pc-90pc risk of Greece leaving the euro – an assessment that Open Europe cautioned strongly against. In Europe, the safest money is always on another fudge. Germany and the ECB were likely to take a political decision to keep Greece inside the eurozone for now, given the fragile situation elsewhere.

But the news last week that the eurozone economy shrunk by 0.6pc in the last quarter of 2012 illustrated what was always the bloc’s greatest challenge: reversing chronic economic malaise. Most fundamentally, reconciling a supranational currency with 17 national democracies remains a challenge. The eurozone’s basic austerity-for-cash prescription continues to fuel tension within individual countries and between the hawkish north and the austerity-fatigued south, testing voters’ patience. The forthcoming Italian elections are turning into a bit of a referendum on EU-mandated austerity, just like the Greek elections last year. Five of the seven main political parties – together polling at around 50pc – have vowed to end cuts. Two parties, Lega Nord and the Five Star Movement, the latter led by comedian-cum-politician Beppe Grillo, even want a referendum on whether the country should remain in the eurozone. The everlasting Silvio Berlusconi is making last-minute gains, in part thanks to a promise to kill what he calls “austerity imposed by Europe”. Against all known principles of common sense, the man still could win. Thankfully, a broadly pro-reform, centre-left coalition led by Pier Luigi Bersani is the most likely outcome, but even then the hope of sweeping economic reforms will be tempered, not least due to those parties’ strong links to the unions.

The Italian elections show how the north and Club Med in many ways are locked into a Catch-22: one wants cash (“solidarity”) first, supervision or discipline second, the other the exact opposite. That dynamic is again evident in the ongoing difficulties in agreeing a bail-out for Cyprus: Germany is unwilling to put in cash for fear of rewarding the bloated Cypriot financial sector. Cyprus resists far-reaching privatisations or significant write-downs of its banking or sovereign debt. This north-south stalemate could become further entrenched if French president Francois Hollande continues to slide towards the Mediterranean bloc, both in terms of political temperament and growth rates (France registered zero growth in 2012). This would weaken the Franco-German axis.

And beyond politics, has the eurozone’s triple crisis – fiscal, banking and competitiveness – really been addressed in any fundamental way? Many eurozone countries are on the path to running a primary surplus – meaning income exceeds outgoings, excluding the cost of servicing a country’s debt. But the eurozone’s overall debt still stands at 90pc of GDP, compared to 70pc in early 2010. Greece, Italy, Portugal and soon probably Cyprus, have debt levels exceeding 120pc of GDP – double what is meant to be allowed under eurozone rules.

The banking sector, too, remains fragile. Thankfully, ECB action helped avoid a massive bank funding crisis last year, but there is a price: eurozone banks have become alarmingly reliant on artificial life support. Liquidity from the ECB to banks now tops €1 trillion (£860bn) – up €140bn on 2009. Even though some banks have started to pay back the cash they owed the ECB early, the eurozone is a long way off a back-stop to allow for wind-downs of bust banks or disentangling of bank and government debt. Overnight interbank lending – a key indicator of banks confidence in the system – remains only half of what it was in 2009 and a third of its peak in 2007. If the crisis were solved, this would surely not be the case.

Finally, by almost every indicator, the single currency is absolutely riddled with economic imbalances, but with no fiscal facility to compensate for them. Encouragingly, Spain, Portugal and in particular Ireland have cut unit labour costs relative to Germany – a key measure of competitiveness - but Italy and France are actually becoming less competitive in relative terms. And imbalances go far beyond labour cost. This year, Greece is expected to contract by over 4pc, Spain by 1.5pc and Cyprus by almost 2pc – while Germany, Finland and others are set for growth. Then there is unemployment. Shockingly, Greek unemployment hit 27pc towards the end of last year, with youth unemployment close to 62pc. Spain is not much better at 26pc and 55pc respectively – and all the scheduled reforms and cuts haven’t even been implemented yet. In Germany, meanwhile, unemployment is at record lows.

In a best-case scenario, the Mediterranean countries will follow the Irish example and continue to squeeze wages and cut costs at home. But in light of domestic political resistance, these imbalances could well continue to test the eurozone’s one-size-fits-all model for a very long time.

So, we have an election fought over EU austerity, political stalemate, a bail-out which no one wants to pay for, abysmal growth forecasts and massive unemployment. There may come a day when the eurozone bounces back and puts us all to shame. But to celebrate now the “end of the crisis” seems to be setting the bar exceptionally low.

Some preliminary thoughts on the stress tests for Spanish banks: lots of optimistic assumptions...

Here is the full report (and the bank-by-bank results) from the latest Spanish bank stress test exercise. Below we provide the key points and our initial thoughts on them.

The tests put the total capital needs of Spanish banks at €59.3bn, but Spanish Deputy Finance Minister Fernando Jiménez Latorre (in the picture) just told journalists during the press conference that, assuming that Spanish banks manage to raise part of the money from other sources, the Spanish government could ask the EFSF for "around €40bn" (as we anticipated here).

Key points: 

• 14 banks assessed, 7 found to be well capitalised, 7 found to need capital injection. Total needs put at €59.3bn. This falls to €53.75bn when the mergers under way and the tax effects are considered;

• €24.7bn of the total amount is earmarked for Bankia alone, with a further €10.8bn for CatalunyaCaixa and €7.2bn for NovaGalicia;

• The adverse economic scenario assessed was: 6.5% cumulative GDP drop, unemployment reaching 27.2% and additional drops in house and land price indices of 25% and 60% respectively, for the three-year period from 2012 to 2014;

• Cumulative credit losses for the in-scope domestic back book of lending assets are approximately €270bn for the adverse (stress) scenario, of which €265bn correspond to the existing book. This compares with cumulative credit losses amounting to approximately €183bn under the base scenario.

Open Europe take: 

• The base case scenario seems overly optimistic, the adverse scenario looks more realistic - although we expect a fall in house prices of around 35% rather than the 25% assumed. The prediction that unemployment will peak at 27.2% also seems optimistic given that there is plenty more austerity and internal devaluation to come while the structural labour market reforms are yet to take effect.

• Oliver Wyman's report strongly assumes that all the previous capital buffers and loan loss provisions have been well implemented with suitable quality of assets. However, this is far from assured;

• The level of non-performing mortgage loans seems incredibly low at 3.3% currently with losses only predicted to rise to 4.1% under the adverse scenario. This number could well be distorted by forbearance (delaying foreclosing on loans likely to default to avoid taking losses) by struggling banks. It will also massively increase if unemployment and economic growth turn out to be worse than predicted;

• The levels of recovery on foreclosed assets seem a bit too positive (admittedly a wide range of between 37% - 79% losses depending on type of asset) given the continuing oversupply in the real estate market in Spain. Until the market has fully adjusted, the huge mismatch between supply and demand is likely to keep resale value on foreclosed assets incredibly low;

• These tests do look to be more intense than the previous ones but ultimately the optimistic assumptions do instantly raise questions over their credibility. The structure of the bailout request is also unlikely to enamour investors, who like to see grand gestures, however, it always positive that taxpayer participation may be limited. 

 

A successful ECB adjustment? Not exactly...

A very technical post, so we apologise in advance, but there is an interesting debate going on regarding the ECB’s decision to cut its deposit rate to 0%.

The move essentially means that banks will no longer receive any return (previously 0.25%) for depositing money (usually excess cash) in the ECB overnight. The hope is that banks will instead lend this money out on the interbank market or use the money to purchase new assets, as they did before the financial and eurozone crises, thereby eventually boosting the level of lending to the real economy.

The past few weeks have seen a debate over what the impact of this move would be. Last night was the first night that the new rate came into effect and, as expected, the level of deposits at the ECB fell significantly – by €483bn. However, the far more important is figuring out where the money went.

As the graph below shows, the money did not in fact make its way to the interbank market or into many new assets, but simply stayed at the ECB but under another heading, ‘current account holdings’.

'Current account holdings' refer to the main financial accounts through which banks conduct their dealings with the ECB. If they wish to access the deposit facility, funds must be transferred from the current account to this facility. Usually this is beneficial as it results in a slightly higher interest rate. However, now both accounts deliver no return.

So clearly, this money has merely been passed from one ECB account to another. That is not to say that it will not leave the ECB and that the deposit rate change will have no impact, but simply that it is yet to happen. After all this is only the first night where the new rate is in effect. That said, we are sceptical of how much impact the new lower deposit rate can actually boost lending, rather than simply boosting demand for already scarce assets (e.g. German short term debt), but we will discuss this in more detail in further posts.