Measuring the ease

In the past few years, the European Central Bank (ECB) has undertaken various measures designed to ease pressures in financial markets. These include providing cheap short-term liquidity to banks and the purchase of peripheral eurozone government bonds.

The measure that has recently had such a big impact on markets has been the ECB’s three-year long-term refinancing operation (LTRO). This was announced at the ECB’s meeting in December 2011 and means that banks can borrow from them at an interest rate of 1 per cent for three years.

The first LTRO was very popular, with 523 banks borrowing a total of €489bn (£409bn) from the central bank.

Any bank wishing to borrow from the ECB can do so, provided they can provide sufficient and acceptable collateral.

The ECB creates the money and credits the bank’s cash account and receives the collateral in return.

There is a range of acceptable collateral, including, but not limited to, all eurozone government debt.

These are valued at the market rate – not on par with Greek or Portuguese bonds – and margin has to be placed by the bank to absorb potential losses on the value of the collateral.

If the value drops below a certain amount, the bank will face a ‘margin call’ where it posts additional funds, with the margin requirements being stricter for lower-rated collateral.

By undertaking the LTRO, the ECB is enlarging the so-called ‘monetary base’ – the loan is therefore technically ‘unsterilised’ until it is repaid – and expanding its balance sheet. Central bank balance sheets have been growing rapidly since the beginning of the financial crisis.

It is worth pointing out that a lot of the money being lent by the ECB is not necessarily feeding through to the wider economy or being lent to other banks.

Indeed, a lot of it is actually being deposited at the one institution the banks trust – the ECB itself. Deposits at the ECB have increased by €200bn since the end of November 2011.

Another three year LTRO is scheduled for February 29 2012.

Predicting how much will be borrowed by banks is very difficult, but some estimates are for roughly another €400bn. Nothing is planned as yet beyond February.

Technically this is not quantitative easing (QE), but the effect has been pretty similar if not even bigger. The ECB is creating money ‘out of thin air’, just like the Bank of England, but the LTRO is a loan whereas proper QE is the purchase of an asset, such as gilts.

In other words, the Bank of England is not expecting the money back, but the ECB is.

Another difference is that, under the LTRO, the bank still retains the credit risk of the assets that it has posted as collateral. They bear the risk of eurozone bonds dropping in value, not the ECB. Under QE, the seller of gilts no longer has to bear the risk of owning them on their balance sheet.