ECB Research TLTRO - no longer our base case

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1 Investment Research General Market Conditions 08 February 2019 TLTRO - no longer our base case TLTRO is not a done deal as the ECB needs a monetary policy justification to conduct another round. Such arguments are not straightforward to find. Consequently, we change our call and no longer expect TLTRO to be announced in March. TLTRO will remain in ECB s toolbox, should it be needed. Banks credit growth and lending rates do not suggest a broken transmission mechanism, however, a potential fragmentation due to higher cost of funds by particularly Italian banks may be the strongest monetary policy argument there. We do not find the argument strong enough for this to be monetary policy. Gaining market attention The discussion of potential additional liquidity measures has received a lot of market attention recently as the maturity of the operations gradually approaches sub 1 year. It is widely viewed that if the ECB doesn t offer new liquidity operations, it would de facto be tightening monetary policy conditions and given the current economic environment that may not be a warranted. However, after the January ECB meeting we lowered our probability of a TLTRO due to two comments. First, the ECB didn t task the committees to examine the liquidity situation as widely expected and secondly Draghi stressed that there must be a case of monetary policy for doing it, so it shouldn't be something that we do it as and they are right as a sectoral measure, as a country-based measure.. We believe that market participants are too complacent by seeing a new TLTRO as a done deal. In the following we examine the arguments to the extend this is monetary policy and argue that the convincing argument of the need for a euro area wide measure is not there. Consequently, we change our call and no longer expect a TLTRO now, but it remains available in ECB s toolbox should it be needed. TLTRO maturity profile TLTRO 1 TLTRO2.1 TLTRO2.2 TLTRO2.3 TLTRO2.4 0 Jun-14 Jun-15 Jun-16 Jun-17 Jun-18 Jun-19 Jun-20 Jun-21 Source: ECB and Danske Bank Note: shaded area indicate potential early repayment Currently, there are still EUR719bn outstanding of the TLTRO, which all mature in March A Bloomberg survey ahead of the January ECB meeting showed that 89% of respondents expected a new long-term loan (TLTRO or LTRO), with more than 60% of those expecting an announcement at the March meeting. Arguments in favour or against a new round of TLTRO In favour Draghi put IT (and to some degree ES) weak lending growth Supporting bank profitability Fragile (and heterogeneous) Italian banking sector Cost of funding may go up, specifically in Italy Contain potential spill-over Extending/ rollover of EUR 722bn outstanding TLTRO NFSR (guideline) No-extension will be a de facto tighter monetary policy Current weak economic data Source: Danske Bank Against Unclear monetary policy reason Strong lending growth in EA as a whole Low lending rates. Repaired transmission mechanism Euro area banking sector is overall solid Most banks have shown market access at decent levels Banks can still access 3m unlimited liquidity (Fixed rate full allotment) Tying monetary policy for a long period in current narrative Banks may not be in breach of NFSR as and it is not binding from Jul. 19 TLTRO still available in ECB's toolbox should it be needed Senior ECB / Euro Area Analyst Piet P. H. Christiansen phai@danskebank.dk Senior Covered Bond Analyst Sverre Holbek holb@danskebank.dk Analyst Aila Mihr amih@danskebank.dk Important disclosures and certifications are contained from page 6 of this report.

2 To fix a specific problem: The history of (T)LTROs ECB has conducted several Longer Term Refinancing Operations (LTRO) since the start of the global financial crisis. Most prominently, the ECB launched two 3-year V(ery)LTRO in 2011/2012 and a series of 8 T(argeted)-LTROs in 2014 and another 4 TLTRO2s in Each of the rounds were announced to address a specific monetary policy transmission problem. In 2011/2012 the (V)LTRO were announced in response of liquidity tightening conditions and an interbank lending collapse, while the TLTRO1 (in 2014) was launched in response to a fragmented transmission mechanism in particular in peripheral economies. In 2016, the TLTRO2 were part of a strong forward guidance package from the ECB. In the period running up to the TLTRO announcement in June 2014, the lose ECB monetary policy stance was not transmitted to the real economy and credit growth developments were hampered in almost all countries. Countries exhibited contracting loan growth dynamics. ECB responded to this supply problem by launching the TLTRO1 (the stick approach ), whereby banks could get funding at the MRO or up to the lending rate depending on certain lending requirements. The TLTRO2 was part of a strong forward guidance package alongside cut of rates to further foster lending growth at very favourable terms to the real economy, as banks could attain funding at MRO or down to the deposit rate (the carrot approach ). Therefore, in all instances, ECB responded to a specific problem. Since the launch of TLTROs in 2014, the monetary policy transmission has gradually improved and is now almost fully repaired (in all countries), which has been accompanied by spread tightening between banking lending rates to the real economy and the monetary policy rates (deposit rate). Since 2015, the lending rates to the real economy (and in turn the spread to the deposit rate) has been broadly constant. Loans growth have recovered markedly since the TLTRO Interest rate on new loans to nonfinancial corporations In short, the (V)LTRO was done to fix a liquidity problem, while the TLTRO were launched to fix a credit transmission problem. The role of excess liquidity and rates Excess liquidity is and has been abundant in the euro area since the ECB started its APP in That is not about to change since the ECB has decided to reinvest the principal maturities in full at least past the first rate hike. We expect reinvestments to take place at least through to the end of Even if new TLTRO are not offered, and excess liquidity would decline after the EUR719bn of TLTRO matures, we still expect liquidity in the Eurosystem to remain abundant. Since the start of the crisis, the ECB has offered unlimited liquidity as its liquidity operations have been conducted on a fixed rate full allotment scheme. The ECB has said that this continues to be the case at least until the end of We see this as a formality to be extended. That also means that even if TLTRO were to come to an end, no liquidity cliff effect is warranted and banks can access unlimited funds for a 3 month horizon. EONIA and excess liquidity Source: Bloomberg History indicate that the short-end of the money market curve reacts to the amount of excess liquidity once it crosses around EUR300bn (current excess liquidity is EUR1.9trl). At that stage, EONIA drifts lower/higher in the ECB rate corridor between the MRO and the deposit rate. However, that level is likely to be higher this time around, but in our view, even with the ECB potentially not extending the TLTRO, we continue to see EONIA hovering in the lower end of the corridor February

3 Lending dynamics are strong except in Italy (and Spain) Credit growth in the euro area is at its strongest level since 2011 at 2.8% (loans to Nonfinancial corporations), albeit the country level data show a heterogeneous pattern across the euro area. In core euro area, led by Germany and France, annual credit growth were 7.6% and 6.2% respectively for loans to non-financial corporations (NFC). Loans to households are pointing to a similar dynamics for the core euro area. More worrying signs are found in the credit growth developments in Italy and Spain. While Spanish loan growth took a dent in H2 2018, it has been relatively good given the improving banking sector since However, Italy is more concerning as it has posted contracting loan growth almost continuously since The TLTRO slowed the banking deleveraging in Italy momentarily, but the negative developments have sped up since the start of 2017 and further intensified in 2018, amid political uncertainty. Loan growth to non-financial corporations Italian banking sector - findings from the BLS The ECB published its bank lending survey two weeks ago, and while the overall picture is ok, it does contain a few worrying signs. Most pressing is the tightening credit standards for Italian enterprises and households (for house purchase), as well as tightening cost of funding / balance sheet constraints. However, the TLTRO wouldn t be able to support the house purchases given the nature of the operation which excludes house purchases in the eligible loan stock. In Q4 2018, credit standards tightened to Italian enterprises due to an increase in the banks risk tolerance as well as risk perceptions were no longer an easing factor. Naturally, that is of concern given the high stock of TLTRO funds they have outstanding (EUR239bn), however tightening standards are significantly below the 2011/ 2012 levels. Italy was the only major euro area country that reported tightening standards. Playing the devil s advocate, one could argue that the drivers of the tightening are selfimposed by lack of a clean-up in the banking sector and domestic policies during the past year, leading to tightening standards for Italian banks. Naturally, the question arises if such a clean-up in the Italian banking sector is a monetary policy case or if this is a banking / fiscal issue. Politics easy but then again At first glance it should be relatively easy to introduce another round of TLTRO as such a monetary policy operation is collateralised, however, as we pointed to above, the ECB deploys monetary policy measures in response to specific problems and currently, there are no imminent problems for the euro area banks. However, without another operation, the ECB would make monetary policy less easy. To balance the argument, ECB president Draghi s 2017 Sintra speech said that a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments not in order to tighten the policy stance, but to keep it broadly unchanged. Finally, Reuters reported on Tuesday that there may be some hesitation in the governing council given the change in presidency by the end of October next year and a reduced willingness to commit beyond his term may be warranted. Credit standards to enterprises is expected to tighten in Q Unit: net percentages of banks reporting tightening credit standards and contributing factors Credit standards to Italian enterprises tightened in Q Unit: net percentages of banks reporting tightening credit standards and contributing factors The prudential ratios argument A much used argument for another round of TLTRO funding that might be needed sooner rather than later is the requirement for banks to hold enough stable funding to cover the duration of their long-term assets, the Net Stable Funding Requirement (NSFR). In detail, the NSFR is defined as the amount of available stable funding (ASF) to required stable funding (RSF). Assets are assigned RSF factors based on their liquidity and residual 3 08 February

4 EU avg. LV RO BG SI LT CY SK MT HU DK HR PT DE IT EE CZ AT ES SE GB PL IE LU FI BE FR NL NO GRE maturity, while only funding and capital available for at least one year is qualifies as 100% ASF. As the remaining maturity falls below 12 months, the ASF factor falls to 50% and then further to 0% as only 6 months or less remains. In isolation, this implies that by June this year, the EU banking sector stands to lose about EUR190bn in stable funding as the remaining maturity of the first TLTRO tranche falls below 12 months. Taken in isolation, this amount seems daunting relative to the total ASF of EUR666bn (EBA QIS data, December 2017). However, the ECB s liquidity operations are collateralised lending: while assets pledged as collateral are assigned a 100% RSF factor, this reverts to the normal RSF once the source of encumbrance rolls off. In other words, the RSF of the asset-side will also fall, reducing the negative net effect on banks NSFR ratios. Furthermore, NSFR requirements are not yet binding; NSFR is being introduced as part of the CRR II package, which is expected to be finalised in H1 19, after which time a two-year phase-in period will apply. Another aspect is the potential impact on banks Liquidity Coverage Ratios (LCRs). Banks may have raised their LCR ratios by placing TLTRO drawings in liquid assets or as excess liquidity with ECB. To the extent that liquidity reserves are used to repay TLTROs, that could put pressure on banks compliance with LCR requirements. However, overall, the EU banking sector appears to have significant buffers in this respect, mitigating TLTRO refinancing risk to some extent. Adding to this, ECB board member Benoit Coeuré noted on 25 January that the ECB will not do a new round of TLTRO because of NSFR. Therefore, we doubt that the impact of the TLTRO run-off on prudential ratios in itself will force the ECB s hand. Funding costs set to rise without the TLTRO Sharply rising funding costs could be of concern to the ECB since it may impair the transmission mechanism. LCR across countries and minimum requirement 350% 300% 250% 200% 150% 100% 50% 0% Source: EBA report on liquidity measures, October 2018 (December 2017 data) Financials ASW spread by country (iboxx indices) 350bp 300bp 250bp 200bp 150bp 100bp 50bp 0bp Source: Markit FR DE NL ES IT Expected gross issuance volumes (EBA survey, Sep 2018) Looking across Europe, banks wholesale funding costs peaked in early January and have since fallen significantly across instruments. However, particularly in Italy but also in Spain to some extent, levels remain elevated relative to their recent history. Hence, market data seems to confirm the conclusions from the bank lending survey. Going forward, market based funding is expected to pick up on a broad basis according to the EBA Report on Funding Plans, driven by the progress in meeting MREL requirements as well as banks looking to replace existing TLTRO drawings with market-based funding. Source: EBA report on banks funding plans So far, however, Italian banks wholesale funding activities have remained modest. Going forward, larger issuance volumes could put additional pressure on spreads. We also note that Italian banks have significant wholesale debt maturities lurking ahead in Italy bonds issued and matured (bn EUR) Maturing financials debt 20bn 18bn 16bn 14bn 12bn 10bn 8bn 6bn 4bn 2bn 0bn DE FR IT ES Source: Bank of Italy Source: Bloomberg and Danske Bank Note: EUR denominated, fixed coupon, min 250m) 4 08 February

5 TLTRO modalities As described above liquidity operations have been deployed to address specific problems, and without a clear specific euro area problem, it will be difficult to tailor a response to this (Italian banking fragility should be addressed via other means, such as the ESM bank recapitalisation). However, should it come, we do expect it to be a much watered down version of the current ones. In such a case, we could envisage that it would be an indexed rate with a sub 3y horizon at the MRO or up to lending rate, in order for this not to make it too attractive a carry trade for banks. The ECB shouldn t want this measure to be seen as increasing profitability of the banks. Furthermore, given the SSM mandate within ECB, the ECB s wish to have banks stand at their own feet should prevail. Conclusion In sum, we do not see the very strong argument of another TLTRO round at this stage as the transmission mechanism is functioning and abundant liquidity is present in the market. However, we acknowledge the risk of the ECB announcing this due to the Draghi put and without announcement it would be de facto tightening, which may not be warranted at this stage. However, with the NSFR date postponed, there should be no urgency to announce this measure. We therefore assign 75% probability of TLTRO not coming at this stage. It will remain in the ECB s toolbox and can be used at later stage should it be needed February

6 Disclosure This research report has been prepared by Danske Bank A/S ( Danske Bank ). The author of this research report is Piet P. H. Christiansen, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. Danske Bank s research reports are prepared in accordance with the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high-quality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from, and do not report to, other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. Expected updates Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research report has been prepared by Danske Bank A/S. It is provided for informational purposes only and should not be considered investment advice. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided herein. This research report is not intended for, and may not be redistributed to, retail customers in the United Kingdom or the United States. This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank s prior written consent February

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