The ECB will find it harder to continue to stick to its separation principle: traditional monetary policy for the economic cycle; non-conventional tools for crisis management.
A rate cute is widely expected next week . The discount rate could be reduced, in an effort to disincentivize cash hoarding by banks. As the reluctance to use the SMP remains high, I discuss the odds for another VLTRO. It is likely to be mentioned in next week's press conference, but I do not expect the ECB to take a decision on this yet.
The problem of the SMP is not the size of the balance sheet of the ECB, as it could be expanded the same way as that of the Swiss National Bank. Beyond the lack of conditionality coming from secondary market purchases, the biggest problem is the lack of commitment of the Central Banks. Every investor expects the ECB to give up when yields reach 7%.
The problems with VLTROs are well known: they do not solve the undercapitalization problems of banks, there is no incentive to improve their balance sheet, and they may reinforce the negative feedback loop between sovereign and bank risk through financial repression.
Dedicated to avoiding a huge redemption risk in the wake of the US money market funds withdrawals last year, VLTROs are also part of the tools put in place to avoid a credit crunch. They could now be used to heal the consequences of a bank run.
The outstanding of household deposits in non-core countries is €3770 bn (left chart). A withdrawal of 25% similar to the run observed in Greece would amount to €950 bn. This gives an example of the potential "mutualization risk" that a joint deposit issuance scheme would have.
The second chart shows that there is a clear link between the fall in deposit outstanding and the rise in MRO/VLTRO cash allotted by the ECB - even though there are other sources for the liquidity shortages of non-core banks.
If the European Central Bank is willing to avoid a credit crunch, it should make sure that the ongoing deleveraging process is not reinforced by the decline in deposits. The chart below shows that the credit to deposit ratio has already declined. Of course, the Senior Loan Officer Survey shows that the demand for loan is collapsing and there is nothing that could be done by the ECB. But it may stand ready to act on the supply side.
The reluctance of the ECB to reuse the SMP (whose outstanding is now €215 bn) could open the door to an expansion of the powers of the ESM. This is clearly unlikely. In addition, even if there were some kind of banking license to act swiftly, any cap in the amount that could be bought would make it useless. It looks like everything has been done in the ESM Treaty of February 2nd for this secondary market purchase option not to be implemented: The ESM "should address contagion" on the basis of "an analysis of the ECB" and conditionality "shall be detailed in a MoU" after a request by a member.
Given the risk of a bank run, which is highlighted by the widening of TARGET 2 imbalances (also a reflection of broad based sudden stop of private capital flows) and the credit crunch risk, a future VLTRO is a real possibility.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.