It is not just that a Greece deal continues to prove elusive that is challenging the euro. Market participants are also digesting the implications of the ECB collateral rule changes. While it appears more likely that the ECB will not cut the main repo rate in March, as previously appeared to be the case, the collateral rule changes mean that the ECB's balance sheet is likely to expand significantly in the period ahead.
In recent months, there has been a clear shift in focus from interest rates per se to central bank balance sheet considerations. In this respect, the fact that many observers remain convinced that the Federal Reserve's balance sheet will expand under a third round of asset purchases in a few months is a significant barrier to stronger US dollar sentiment. The greenback's recovery in latter part of last year is understood by many as more a function of a weaker euro than a stronger dollar in its own right.
There are three aspects of the new collateral rules that are noteworthy.
First, the decision to liberalize the collateral rules was not unanimous. The Bundesbank objected and it is possible that another central bank or two did not vote with the majority. Although a recent publication in Germany said that Draghi is known to his friends as the "Prussian Roman", the Bundesbank does not appear to agree. It objected to sovereign bond purchases initiated under Trichet and now is objecting to the collateral liberalization under Draghi.
Second, seven central banks (France, Austria, Italy, Spain, Portugal, Ireland and Cyprus) proposed the liberalization of acceptable collateral. Consistent with the announcement following the December ECB meeting, there has been some devolution of power in this matter to the national central banks. There will be national eligibility criteria and they will bear the risks of the new collateral.
The ECB has ventured into uncharted waters here and the risk is the development of a two-tier euro zone. It will be in the hands of investors, however, whether there is a stigma or reward for those operating under more liberal collateral rules.
Draghi acknowledged that more liberal collateral rules pose new risks, but he argued the risks would be well managed. Haircuts on the collateral appears one way to manage the risks. The participating national central banks, will determine the eligibility criteria and the haircuts (risk control measures).
Cyprus is among the first of the national central banks to publish their new rules. They are cited here to give a sense of what is involved. There will be a 10% haircut on euro denominated corporate loans used for collateral that have a default probability of 0.5%. At the other extreme is a 895 haircut for those loans that have a 1.5% risk of default and denominated in yen.
The ECB guidelines indicate that national central banks cannot take loans as collateral that have a default probability of more than 1.5%. The Bank of Italy will reportedly not accept loans as collateral with a default probability of more than 1%.
The ECB guidelines seem to suggest there is not minimum size of a loan that can be used as collateral. This allows loans to small and medium sized businesses to also be included as collateral. Almost 10% of European bank loans (which are about one third of their assets which are estimated to be near 24 trillion euros) are to small and medium sized business. Italian banks appear to have the highest ratio of corporate loans to assets (~40%).
This brings us to the third key issue here which how much more borrowing from the ECB will take place under the new collateral rules. This in turn gives some sense of how much the ECB's balance sheet will grow. Estimates here seem to be largely a product of educated guess work.
The Director General of the Bank of Italy was quoted on the wires suggesting Italian banks may borrow an additional 70 billion euros Press reports suggest Irish banks may opted for new ECB borrowing instead of self-issue bonds, which the government charges 100 bp to issue.
Overall, the new collateral rules could see new borrowings of 200-400 billion euros. This could see the ECB's balance sheet expand about 10-20% from its current 2.3 trillion euro size.
Recall that the consensus for the next 3-year long-term repo at the end of the month was for 400-500 billion euros. Draghi himself suggested that the take-down would likely be around the same as the first (almost 500 billion euros gross, almost 200 billion net the roll-over of other facilities into the 3-year LTRO). What is involved with the collateral changes seem to be more than just how that LTRO facility will be tapped as the market's estimates were made prior to these collateral rule changes.
While there may be some overlap, the risk is that the ECB's balance sheet expands more than the market had estimated prior to these collateral rule changes. Moreover, it is not just the size of the balance sheet, which attracts the attention of many who emphasize the quantity of money.
Some adjustment needs to be made for the quality of the assets, haircuts and all. The Fed and BOE buy what are regarded as low risk assets: Gilts and Treasuries. It is true the Fed is buying mortgage backed securities, but since Fannie and Freddie have been nationalized, the risk on MBS seems to be minimal. For its part, the Bank of Japan buys considerably riskier assets, including ETFs and REITs. The ECB has expanded its balance sheet through buying bonds that are either below investment grade (Greece and Portugal) or that the private sector does (or did) not want, like Italian and Spanish bonds.
The other dimension here is the price of money. Like Trichet, Draghi seems to recognize a fundamental difference between liquidity measures, like the LTRO, and monetary policy proper, the setting of interest rates. By recognizing preliminary stability in the euro zone economy, Draghi appeared to signal a high bar to a rate cut next month. However, further deterioration, if those downside risks he acknowledged materialize, as we suspect them to, will likely be responded to by lower interest rates. The immediate focus is on liquidity and the ECB continues to pump it out.