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Central Banking 101: the EONIA heartbeat returns

by Carrie Thu Jan 23rd, 2014 at 06:21:45 PM EST

Cross-posted from The Court Astrologer

If you google EONIA heartbeat the top three hits are my own European Tribune blogs

and a Nordea research note from 16 July 2013, Liquidity draining & EUR short end which has the following to say:
EONIA heartbeat pattern has returned...

Before December 2011, EONIA tended to spike on the last day of the maintenance period, as a result of fine tuning operations conducted by the ECB. These operations were suspended in the end of 2011 and the pattern wasn't seen any longer. Since the LTRO repayments started however, EONIA has spiked in the end of the month/quarter, and the largest spike in over a year occurred in the end of Q2 this year.

I don't think that the ECB fine-tuning operations were suspended. What happened was indeed that the LTROs flooded the banking sector with so much excess liquidity that banks no longer needed extra liquidity at the end of ECB reserve periods in order to meet their reserve requirements. But the weekly refinancing operations which the fine-tuning operations are part of still took place.

EONIA stands for Euro OverNight Index Average, and represents the average rate at which banks lend each other money overnight. The function of this overnight lending (and related concepts such as the ECB policy rates, required reserves and maintenance periods) was explained in my first Central Banking 101 post above.

The "EONIA heartbeat" pattern was more clearly seen for a period of 10 months between August 2009 and June 2010 (click the charts to expand):
As we can see from this chart, EONIA stayed roughly constant slightly above the ECB's deposit rate, but spiked on the last day of each ECB reserve maintenance period. The reason for this is that banks incur an opportunity cost for having cash parked as ECB reserves, so normally they keep reserves below their required amount. As the required reserves are computed as a monthly average, on the last day of the reserve maintenance period banks will borrow the funds necessary to meet the reserve requirement. The sudden demand for liquidity raises interbank lending rates, but only for the one day when this liquidity is needed.

The thing is, right after June 2010 the EONIA developed "tachycardia":
I have marked the start of the ECB's bond purchases (Securities Market Purchases, or SMP) on 10 May 2010 because I think it is clear that this is correlated with the start of the tachycardia. The reason is not the bond purchases themselves, which would have naturally improved the liquidity position of European banks, but the fact that the ECB "sterilised" these purchases by draining liquidity from the system in an amount equal to its SMP holdings. The ECB rate raises in mid-2011 visibly didn't help. Personally, I believe Trichet's governing council took these decisions (to sterilize and to raise rates) under pressure from Axel Weber and Jürgen Stark. The rate raises may perhaps be excused by the fact that inflation was trending upwards at the time and the ECB has an idiotically single-minded anti-inflation mandate. However, the sterilization was in my opinion a serious "unforced mistake". I have argued in my previous blogs on this issue that bond purchases don't need to be sterilised and in fact sterilization is contractionary. Here's why.

In 2009, faced with a disintegrating interbank market, the ECB decided to switch its main refinancing operations from "fixed tender" (the ECB would decide the maximum amount of liquidity it was willing to supply, at the target interest rate) to "fixed rate, unlimited tender" (the ECB would lend freely, against eligible collateral, at the reference rate). Now, Eurozone government bonds of the kind the ECB bought in the SMP were eligible collateral for ECB refinancing operations, so after 2009 they could be turned into cash at will (at a small haircut). Now, if you have a bond that you can repo for cash at your sole option, selling it for cash to the ECB really makes little difference to your liquidity position. Therefore, banks which needed liquidity and had SMP-eligible bonds in hand were already likely to be repoing them weekly at the discount window anyway. So the liquidity injected by the ECB through the bond purchases was already in the system.

"Sterilization" means to offer banks to deposit cash with the ECB for a week, at the ECB's reference rate. In this way, an amount of cash equal to the ECB's SMP holdings was withdrawn from the banking system. But as we have argued, this was not extra liquidity that was injected by the SMP: the liquidity was already there. So the net effect of sterilization is to actually decrease system liquidity by the amount of its bond purchases. Therefore, the worse the sovereign debt crisis got, the more liquidity the ECB withdrew, only making matters worse. Then the ECB went and raised rates twice in the middle of a recession responding to cost-push inflation (from commodity imports) and the notional inflationary effects of VAT raises from austerity policies. A wholesale policy disaster, if you ask me.

The EONIA Tachycardia stopped at the end of 2011. This can be seen more clearly by rebasing interest rates around the ECB's reference rate, as in the top half of the following chart:

We can see that there is a single end-of-year liquidity spike after the first 3-year LTRO, and then the EONIA heartbeat itself, let alone the tachycardia, disappeared. So, and that was the point of my second Central Banking 101 post, it was the LTRO and nothing else that got rid of the EONIA tachycardia. Even the "whatever it takes" OMT speech didn't have a noticeable effect on the spread of EONIA over the ECB rates. The SMP sterilization continued, but now there was so much excess liquidity in the system that it didn't matter.

Nevertheless, as can be seen more clearly in the bottom chart and was noticed by Nordea already six months ago, the EONIA heartbeat has returned. This can only be because the excess liquidity is gone, and the reason is the unwinding (prematurely, in my opinion and based on its effects on EONIA) of the LTRO. Banks have been encouraged to return the 3Y LTRO liquidity a year after it was borrowed. Part of this has been an attempt to signal to "the market" that the health of individual banks was sound, and even that the health of entire national banking systems such as Spain or Italy was good. But already in mid-2013 the EONIA hearbeat returned, and at the end of 2013 SMP sterilization failed a few times.

Failure of SMP sterilization scares de bejeesus out of inflation hawks, but as I argued at the start of 2011 when it happened a couple of times, failures of sterilization indicate that the ECB is trying to drain liquidity that simply isn't there.

So, here we are, three years later liquidity is again so tight that sterilization is failing, and all the hawks can think of is worry that the SMP is becoming "Quantitative Easing through the back door". With such thinking, we have a long crisis ahead of us.

Francesco Papadia is a former Director General for Market Operations at the European Central Bank and Chair of the Board of Primary Collateralised Securities. He blogs at Money matters? Perspectives on Monetary Policy

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman
by Carrie (migeru at eurotrib dot com) on Fri Jan 24th, 2014 at 04:05:57 AM EST
So the Germans think there is a threat of excessive liquidity?  I think that means we have a threshold question to answer: Are they simply being disingenuous, or did they actually get into the brown acid?
by rifek on Sun Feb 16th, 2014 at 01:24:50 PM EST
[ Parent ]
I think they really believe it, which is extraordinary considering we're talking about trained economists for the most part...

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman
by Carrie (migeru at eurotrib dot com) on Sun Feb 16th, 2014 at 03:13:06 PM EST
[ Parent ]
Germany has a particular set of economic myths you have to buy into if you want to be a member of the society.  First is that currency devaluation is the greatest evil, disregarding that it took losing world wars to create what they fear and that they came through both occurrences.
by rifek on Mon Feb 17th, 2014 at 03:25:02 PM EST
[ Parent ]
Ok, so what happens now?

Liquidity is drained from the banks, so are we facing a renewed banking crisis? Will the markets believe that this poses a risk to governments or believe in the common banking resolution mechanisms ability to handle it? And will a speculative attack on exposed governments lead to a renewed periphery crisis or will the ECB back the governments?

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by A swedish kind of death on Fri Jan 24th, 2014 at 08:58:04 AM EST
Voices are being raised asking the ECB to do something already. Draghi said that "an unwarranted rise" of short-term rates would be a condition for additional monetary easing. However, every time SMP sterilization fails to drain the desired amount the inflation hawks freak out. So we have two competing signals: EONIA spiking signals lack of liquidity and SMP sterilization failures, while also signalling lack of liquidity, is mistakenly interpreted as excess liquidity. So this may delay the application of "unconventional" expansionary monetary policy.

The ECB's own metrics are at fault here: their models tell them that unsterilised SMP liquidity contributes to "excess liquidity" in the system.

I wouldn't call this a brewing banking crisis, though. I don't think tight liquidity equates to solvency problems, and the same banks that have been repaying the LTRO could well repo the LTRO assets at the ECB's weekly liquidity auctions which are still "unlimited tender".

So I don't worry too much about a relatively high EONIA figure. The real issue in the Eurozone right now is the geographical fragmentation of lending to the "real economy". Peripheral Euro firms are paying maybe 3% more for bank loans than core Euro firms, and lending volumes are down, and this seems not to be improving.

The "asset quality review" and stress tests to be conducted by the ECB this year should force some banks into restructuring, possibly in Italy and France, maybe even in Germany. Spanish banks are supposed to have just come out of a rescue and "should" be okay, but then again we know the rescue wasn't as big as it should have. So that's where another Bank-Sovereign crisis might occur in the near term.

It should be kept in mind that there is no European bank resolution fund worth mentioning and there won't be for 5 to 10 years. So ultimately the ECB may be forced to trigger the OMT and buy bonds of distressed countries.

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman

by Carrie (migeru at eurotrib dot com) on Fri Jan 24th, 2014 at 07:26:48 PM EST
[ Parent ]

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