As we approach the end of the year, I can only hope that 2012 will bring us a bit more clarity.
However, the results of the latest VLTRO (very long-term refinancing operation), released this morning, constitute a new and striking example of the chronic schizophrenia to which financial markets are being exposed.
Average consensus expectations placed bank borrowing at slightly over €300 billion via this new ECB 3-year 1% interest facility, but total take-in came to a whopping €489 billion. While we might've expected such a high figure to increase risk on, bolster risky assets and push down interbank interest rates, just the opposite occurred!
Investors ended up deciding to focus on the fact that such a figure highlighted just how needy banks are and, thus, their weakness. This led to a hike in Euribor futures rates and a new plunge on eurozone peripheral nation debt markets and stock markets.
The announcement by the Italian stock exchange that Italian banks had the government guarantee the €40 billion in bonds to use them as collateral at the ECB today did not reassure investors. Bank shares are now showing the steepest declines on European stock markets.
These fits of anxiety illustrate just how much the European economy is suffering from the total disintegration of interbank financing markets which, as we have repeatedly emphasised, constitute a vital element in the "money creation" process.
Banks, not the ECB, create money
Despite the prevailing monetarist narrative and ECB dogma, commercial banks, and not central banks, are the ones who direct money supply volume. The ECB can, at best, use its benchmark interest rates to influence economic activity and thus the volume of loan demand for the real economy, but banks are at the origin of money creation.
Let's briefly review how a modern monetary system works during normal times.
1. If Bank A judges a client to be credit worthy, following examination of his or her application, it will grant him a loan. In accounting terms, it credits the current account of the client in the amount of €X and books said amount to its loan assets. As long as the client leaves that amount in his account, the bank has no need to seek funds elsewhere. As such, it has created €X amount of money. I will leave aside the details on required reserves, which, at worst, are provide by the central bank, and some countries function very well without them. The individual in charge of these loans therefore does not need to verify that the bank possesses ex-ante these funds in its vaults, or, to borrow what has become the classical phrase, "loans create deposits".
2. The client carries out the purchase for which he borrowed money in the first place and this €X amount is transferred to Bank B where the seller has his account. Bank A must therefore obtain €X to balance its balance sheet.
3. This is where the interbank market comes into play, because Bank B will lend it money as long as it can obtain from Bank A a higher interest rate than that paid by the central bank's depository facility (today 0.25%) . The rate will fix between this deposit rate and the ECB marginal rate (1.75%). In reality, it will come to about the ECB's refinancing rate (1%), which enables banks to obtain financing on a weekly basis. it also serves as a benchmark.
In order to reduce the mismatch between the maturity of its loan (often several years) and that of its overnight borrowing, Bank A will borrow (preferably) for a period of three months (or more) at the Euribor rate, which generally follows the ECB's refinancing rate, depending on expectations of upcoming changes.
And thus the loop the is closed. Sum €X, injected into the system, is converted into an asset on Bank A's balance sheet (loan to its client) and into a liability for the debt to Bank B. On Bank B's balance sheet, its loan to Bank A is recognised as an asset and its client's deposit is booked as a liability.
But the interbank market is broken
And with it, breaks the loop, because we are no longer, in any way, shape or form, in normal times.
In effect, since the outbreak of the eurozone sovereign debt crisis, the Euribor market, representing term funding, is dead.
As it is, only the major eurozone banks agree to lend each other money on the overnight segment, leaving all the peripheral or smaller banks without access to interbank financing. No bank is now willing to accept the credit risk of a counterpart deemed weak, either due to its nationality or due to its exposure to PIIGS nation debt. Cash rich banks are not going to fight for a few basis points in interest more than offered by the ECB depository facility, and the vast bulk of banks' surplus reserves are thus in the ECB's vaults.
Moreover, once we get into the longer maturities, like in the case of the 3-month Euribor, there are just no transactions!
The eurozone credit market has thus become totally dysfunctional. Only banks with surplus reserves can lend money while the others can only sell off assets (deleveraging) or seek needed funds from the ECB. These distressed banks are mainly located in the PIIGS nations (from which the flight of deposits). Given that they have traditionally been the main buyers of their respective governments' debt, this banking crisis is heightening the PIIGS nation debt crisis with the establishment of a vicious cycle.
The ECB attempts to substitute itself for the interbank market
Banks that saw their deposits dissipate as they headed to the northern countries no longer have any other solution but to seek funds during refinancing operations. Especially since they can no longer raise capital, be it via stock or bond issues.
That is why the ECB introduced new 3-month, 6-month and 1-year refinancing facilities at the outbreak of the crisis, the latest one being the 3-year operation this morning. It is thus playing a vital role in the re-intermediation of the interbank market, with its acceptance of banks' surplus reserves at its depository facility (at 0.25%) while lending to banks in need of funds via its Refi operations (at 1%).
Moreover, it has agreed to meet all funding demands regardless of amount at an pre-announced rate, in contrast to its pre-crisis operational mode.
But there is a big fat fly in the ointment: the collateral!
Unlike the non-collateral loans negotiated in the past on the interbank market, the ECB requires collateral from banks seeking funds at its refinancing operations.
This collateral, which mainly consisted of high-rated government debt initially, is meant to protect the ECB from all risk loss on these loans, should one of the banks go bankrupt. Moreover, it applies a haircut on said collateral. For example, a bank must commit €110 in collateral for each €100 in loan money. This protects the central bank from possible collateral impairment in case of loan default.
Here again, the ECB has significantly altered its policy since the outbreak of the crisis, given that is accepting increasingly lower grade collateral, having even suspended this requirement in the case of Greek debt. If it had not done so, all the Greek banks would have immediately gone bankrupt. In the case of the recent 3-year very long-term refinancing operation, it even says that it would accept a wider range of assets than in the past, like those accepted by national central banks for their Emergency Liquidity Assistance programmes (ELA).
Consequently, it now accepts, for the first time ever, performing loans from the banks' own balance sheets as collateral, thus excluding any crediting rating criterion and requiring the central bank to build its own credit analysis department!
However, it appears that these measures are insufficient, since the disappointment expressed by markets today is undoubtedly due in part to the collateral creation carried out yesterday by certain Italian banks.
They effectively created €40 billion in bank bonds, probably traded among themselves to avoid having to truly raise cash, backed by the Italian state. This move enabled them to use these bonds for this morning's VLTRO and raise €40 billion in cash in a vacuum. The Italian state, as the sole counterpart, is exposed by this collateral to new off-balance sheet debt totalling €40 billion. This represents only a potential loss, since the banks involved would have to go belly up for the collateral to be used.
But while we imagine that the €40 billion may be used by Italian banks to subscribe to their country's new debt issues, the case shows just the utter hypocrisy and fruitlessness of the ECB's efforts to avoid appearing as the lender of last resort.
This manipulation also illustrates just how much banks are in need of quality collateral and therein lies the greatest danger for the European economy.
Impact on asset allocation biases
You would have to be clever indeed to figure out a strong short-term position, based on all this mess. We neutralised our asset allocation biases following the post-VLTRO peak, and all biases are Risk On since the news of the Italian manoeuvre.
I will tell you straight up that I lack any sense of confidence or visibility to provide any sort of advice this late in the year, as liquidity evaporates like snow on a hot sunny day.
There remains our advice on some Euribor option positions, but more by the relative value of volatility curves than genuine directional conviction.
I hope that the holiday season will bring a bit more serenity, following this "exceptional" (not necessarily in the positive sense of the word) 2011, but I fear that 2012 will be just as bad!
I will like to wish all those to whom I have said spoken directly a very happy holiday season.
As a bonus, I am providing a graph tracing M3 growth in the eurozone since 1980. It should definitively put to rest the notion, dating from monetarism and another epoch, that the ECB directs money supply.
Eurozone Money Creation since 1980 - (click to expand)
We can clearly see the rupture in October 2008. M3 had never grown at such an anaemic pace.
For the period from 1994 to 2000, when M3 increased by an average of just 4.10% per annum, core inflation on the eurozone contracted from +3% to a mere +1%.
It was not until the boom credit years between 2000 and 2008, when M3 grew at an annual average of 8.85%, that core inflation climbed to an annual average of 1.80%, given a range of 1.20/2.60).
Since October 2008, annual core inflation has averaged 1.3% with a range of 0.80/1.60 (last month), as the European Central Bank's balance sheet has bloated to a record €2,493 billion, up 71% since October 2008!
It is thus only logical to hear a bit less from those who had been going on month after month about hyperinflation risk in Western nations due to the expansion of central banks' balance sheets.
For those who believe, like I do, that the main inflation driver is a combination of a booming credit market and too-easy fiscal and monetary policies, rest assured: Given a banking system whose gears are totally stuck, and that's leaving aside the balance sheet restrictions to come and a slew of generalised austerity measures imposed by our German partners, if there is truly a risk on the eurozone today, it is still deflation.
Additional disclosure: Long 18 years OAT and 28 years BTP Zero Coupons, EDF Corp 3 Years 4.5%, Greece 1 Y and 8 Y bonds, Thaler's Corner.