Overview:

• The ECB’s TLTRO programme begins next month. The funding should help ease financial conditions somewhat, allowing banks to refinance more cheaply.
• But the TLTROs are likely to have only a modest impact on country differences in credit risk, which are a key cause of the elevated interest rates on loans and the steady decline in lending in the periphery.
• While we expect bank lending eventually to pick up in line with the broader economic recovery, the risks remain clearly skewed to the downside. And so, if the TLTROs do indeed offer little more than a placebo for the euro area’s ills, they may be simply a step on the road to the more powerful remedy of QE. 

The limited market response to last weekend’s Banco Esprito Santo resolution highlighted the success euro area policymakers have had in restoring stability to the euro area’s banking sector. But, while wholesale collapse is no longer on the cards, the banks remain a constraint on economic recovery. Fragmentation across countries remains high, with declines in lending still marked and interest rates elevated at the periphery. And despite easing over recent quarters, lending standards remain tight. The Targeted LTROs (“TLTROs”) – new cheap fixed-rate funds with a maturity of up to four years – contained in the ECB’s June policy package were designed specifically to remedy these banking sector ills. With the first operation scheduled for next month, will they?

The TLTROs should certainly boost euro area liquidity. They seem designed to encourage a large take-up of funds, including the lack of strings attached to funds borrowed in the two ‘first phase’ tenders in September and December, significantly more generous terms than the BoE’s Funding for Lending Scheme. With up to €400bn on offer under the first phase, theoretically in total close to €1tn will be available.

For several reasons, however, and as Draghi appeared to concede yesterday, we expect take-up to fall some way short of the maximum. For starters, some banks – not least those in Germany, which are eligible for the largest share of funds under the first stage but by July had repaid all but €16bn of the original LTRO funds – might have little appetite for the new funds. Until end-2016 the ECB’s regular refi operations will offer unlimited shorter-term funds 10bps cheaper than the TLTRO money for as long as policy rates remain unchanged (as we think they will). Additionally, opportunities for relatively low-risk carry trades, that partly motivated banks to bid for the original LTRO funds, are scarce. Sovereign yields have fallen to very low levels (this morning Spanish 2Y yields were less than 5bps above the cost of the TLTROs). Many banks, meanwhile, will continue to deleverage in 2015, limiting the amount of funds they might draw under the second phase. And the net impact on liquidity of the TLTROs will anyway be reduced by the continued repayment of LTRO funds.

Nevertheless, we do expect the TLTRO take-up to be sufficient to maintain ample excess ECB liquidity. That should keep money market rates close to their current exceptionally low levels. Indeed, also reflecting the latest rate cuts, since the June package was announced, we have seen money market conditions ease across the entire maturity range. Overnight EONIA now stands 13bps lower than on the eve of the June meeting, 3 month EURIBOR is 14bps lower, end-month pressure on short rates has fallen, and longer-term interest rates are also significantly lower.

A more important feature of the TLTROs is the cheap re-financing opportunity (at 0.25%) that they offer banks for the coming four years. While banks will wish to maintain a diversified liability structure, the resulting fall in interest expenses – whether through lower bond debt service costs or deposit rates – should be greater for banks at the periphery. Even the highest-rated Spanish and Italian banks’ senior unsecured 2Y bonds currently yield at least 0.9%, while the average rate on new deposits up to 1 year in Italy is almost 1½ppts higher than the cost of TLTRO funds. With incentives to lend increased by the conditionality of the second phase of the TLTROs, we expect some of the benefit of the lower cost of funds to be passed on to borrowers in terms of lower interest rates on new loans. Indeed, the ECB’s latest lending survey – reflecting conditions following the announcement of the latest ECB policy package – suggested that banks’ improved liquidity positions and declines in cost of funds already contributed to an easing of credit conditions on loans to enterprises for the first time since Q207. 

However, the higher cost of funding is not the sole reason for weak lending and divergent interest rates between countries. Differing credit risk is also key. Indeed, judging from recent relative loan-loss impairments, it is possibly the most important factor. A range of cyclical and structural factors suggest that interest rates on loans at the periphery should remain higher than at the core, however cheap the cost of funds. Add to that further headwinds from increasingly higher regulatory capital requirements and sluggish (though improving) credit demand and it is easy to see why credit growth has been negative in recent years. And it is also easy to see why lending – particularly at the periphery – will continue to be far from vigorous with or without the TLTROs.

But this doesn’t mean that bank lending will inexorably decline. A longer-term view at credit cycles in advanced economies suggests that they invariably eventually turn up following sharp downswings. With GDP now having risen for five consecutive quarters, the rate of decline in bank lending has recently slowed, reducing the drag on growth from the banking sector. Lending to firms has already broadly stabilised in Germany and France, and slowed its pace of contraction in Italy and, to a lesser extent, Spain. According to our central forecast of continued gradually firming economic recovery, we expect overall lending to non-financial corporations in the euro area to pick up around the turn of the year. The chart below compares our illustrative central scenarios of lending to the private sector excluding housing-related loans (i.e. the stock of TLTRO-eligible lending) in Germany, Spain and the euro area as a whole.

TLTRO-eligible lending forecast*

*Lending to the private sector excluding housing-related loans. Source: ECB and Daiwa Capital Markets Europe Ltd. 

The overall impact of the TLTROs, however, is bound to remain highly uncertain and a matter for debate. Indeed, the continued decline in lending to non-financial corporations in the UK despite the FLS and recent very strong GDP growth might add to suspicions that the overall impact of the TLTROs will be limited. And as the recent softening of macroeconomic data underscores, the risks to our euro area forecasts – of lending, growth and inflation – are clearly skewed to the downside. If those downside risks crystallise, and the TLTROs do indeed offer little more than a placebo for the euro area’s ills, the ECB is likely to have little choice but to resort to the more powerful remedy of QE.