European Central Bank: Three-Year Long-Term Refinancing Operations

The announcement of the three-year Long-Term Refinancing Operations (LTROs) by the European Central Bank (ECB) on December 8, 2011, signaled the beginning of the largest ECB market liquidity programs to date. Continued and increasing liquidity-related pressures in the form of ballooning financial market credit default swap (CDS) spreads, Euro-area volatility, and interbank lending rates prompted a much more forceful ECB response than what had been done previously. The LTROs, using a repurchase (repo) agreement auction mechanism, allowed any Eurozone financial institution to tap essentially unlimited funding at a fixed rate of just 1%. Because the three-year LTROs were so similar to their shorter-maturity counterparts, the types of eligible collateral were almost identical, though the three-year operations were slightly less strict with the types of asset-backed securities (ABS), loans, and debts that could be pledged. The first operation, conducted on December 22, 2011, saw 523 banks draw €489.2 billion in funding, and the second operation, finalized on February 29, 2012, saw 800 banks draw €529.5 billion. Much of the liquidity, rather than being put into private credit markets, was placed at the ECB deposit facility to supplement the interbank lending market. Banks that were more vulnerable to a credit crunch, often located in peripheral countries such as Spain and Italy, tended to use the facility more and also drove the increase in the supply of private credit. Less at-risk institutions tended to engage in “reach-for-yield” strategies with debt from riskier sovereigns. Post-crisis evaluations were mixed, but analysts tend to agree that the facilities helped ease the initial shock in the Euro-area money market and reduce the impact of the credit crunch on the broader economy.

Despite the acute pressures of the Global Financial Crisis having passed, conditions in European interbank lending and money markets continued to deteriorate through 2011. This was apparent in ballooning financial market CDS spreads, interbank lending rates, and money market volatility. Increasing liquidity pressures prompted the European Central Bank (ECB) to respond more forcefully, with the announcement of two three-year Long-Term Refinancing Operations (LTROs) on December 8, 2011. Previously, the ECB had conducted LTROs and other refinancing operations to support monetary policy goals and address liquidity pressures. But the earlier LTROs had maturity horizons of no more than one year.

The three-year LTROs were conducted via an auction mechanism. These auctions allowed European financial institutions to bid for funding in the form of repurchase (repo) agreements, with the ECB as the counterparty. European financial institutions with eligible collateral could bid on essentially unlimited amounts of funding, as the ECB did not specify a hard cap. The repos were auctioned at a fixed rate of 1%.

Eligible collateral was expanded from previous operations to include asset-backed securities (ABS) with a second-best rating of at least “single-A” at issuance that would continue to hold that rating; assets made up of loans to small and medium-sized enterprises (SMEs); and government-guaranteed liabilities. Banks that participated in the ECB’s earlier one-year LTRO in October 2011 were also given an option to lengthen the maturity of repo agreements obtained there to three years on December 22, 2011, the day of the first auction. The first operation saw 523 banks draw €489.2 billion in funding, and the second operation, finalized on February 29, 2012, saw 800 banks draw €529.5 billion for a grand total of approximately €1.02 trillion.

The three-year LTRO program was the ECB’s largest market liquidity program ever. It received mixed reviews. The ECB argued that the program had eased strains in European money markets and helped to prevent a Euro-wide credit crunch. Lenders who were most vulnerable to the credit crunch, often in peripheral countries like Italy and Spain, tended to use the facility more and were the main drivers of private credit growth. While credit growth contracted, one analysis concluded that it would have contracted more if the LTROs had not been in place. Many lenders, particularly those that were less vulnerable, opted to use the cheap financing to invest in high-yield government bonds. Conversely, much of the funding was deposited at the ECB deposit facility, suggesting that the ECB became a large substitute in the interbank lending market.

Because of the massive size of the program, the three-year LTROs have been quite heavily scrutinized by academics, journalists, and politicians alike. Generally speaking, institutions that were most acutely distressed during the sovereign debt crisis tended to use the facilities the most. The ECB stated that banks that were more risky tended to bid more at the LTROs, and that even if private markets were able to provide some funding to banks, there was still a heavy incentive to borrow from the facility. However, they stated that “by improving funding conditions, the ECB may have prevented the disorderly shedding of assets, which would have placed certain financial market sectors under pressure” as well as emphasizing a belief that the introduction of these programs contained spillover effects to larger markets (ECB Monthly Bulletin, March 2012).

This rationale was very clear because, while there was not significant growth in private credit or bank lending relative to the size of the program, it was effective in halting the freefall and ultimately stabilizing these two channels. Additionally, spillover effects from the financial sector to the real economy, which was one of the ECB’s chief concerns when designing the program, appeared to have been significantly lessened owing to the increase in system-wide liquidity.

One study by the National Bank of Belgium estimated that Euro-area output and inflation were significantly impacted and would have been more than 1% lower without the operations (Boeckx et al. 2017). Demand for sovereign debt was also positively impacted, despite not being a primary objective of the program. In Spain, Italy, and Ireland, sovereign debt yields decreased around the time of the announcement, with the largest decrease being 51 basis points for Spanish two-year bonds (Krishnamurthy et al. 2017).

Despite the seemingly robust impact on sovereign debt markets and macroeconomic aggregates, the results were mixed for bank lending, which was the primary area the ECB was trying to affect. In a paper published in November 2018, Stine Louise Daetz and her coauthors emphasized that, while these programs appeared to have halted the decline in corporate investment, there was no significant increase in lending either. Distressed lenders did not lend more heavily. However, companies that were able to obtain new loans from lenders who received LTRO financing increased their investment. Finally, the authors provided an interesting counterfactual analysis, explaining that non-Eurozone companies that did not have direct access to LTRO financing decreased their investment more than those in the Eurozone (Daetz et al. 2018).

Some analysts argued that the LTROs did not adequately address their primary goals. Italian and Spanish bond yields, while positively impacted by the first round of three-year LTROs, still continued to increase in the later parts of 2012. Spain specifically saw a precipitous increase in its 10-year bond yield, from 5% to 7.6% from March 2012 to July 2012 (Sia Partners 2012). The deteriorating quality of some sovereign debt was also an issue both at the ECB and in periphery banks, which had bought the debt in bulk. For the ECB, a default by any of these periphery countries, however unlikely, would seriously damage the quality of some of the assets on the ECB’s balance sheet. For periphery banks, Sia Partners used Fitch downgrading Santander and BBVA to BBB shortly after doing the same to Spain’s credit rating a week prior as an example, suggesting that many of these banks were now tightly tied to their sovereigns. The Economist echoed similar sentiment, arguing that the austerity measures that Spain had instituted were actually harming its return to economic growth, and that the acute phase of the crisis was still quite close (“Draghi strikes back II”).

One evaluation written by Jean Pisani-Ferry and Guntram Wolff called these operations the Eurozone equivalent of QE, but that it did not have the same impact as its sister program. This was predicated on the fact that approximately €700 billion was put into the ECB deposit facility rather than lent out, suggesting that the ECB had become a large substitute in the interbank lending market.^FNSee Figure 2 for more information. Additionally, the authors mentioned significant asymmetry in the behavior of banks in the northern part of the Eurozone versus the southern part, explaining that southern European banks are much more heavily reliant on refinancing operations and still have decreased the amount of lending done, contrary to institutions in northern Europe. This asymmetry also extended to the behavior of highly-rated (AAA) issuers, which saw a minimal impact on the yield curve, compared to financially constrained issuers. The authors finished by discussing that the lack of a banking and fiscal union and substantial differences amongst Euro members contributed to massive monetary policy instruments like the LTROs not being as effective (Pisani-Ferry and Wolff 2012).

Figure 3: Key ECB Interest Rates (%)