ECB Policy

HOW ECB LONG-TERM REFINANCING HELPED TO EASE EUROZONE WOES

The European Central Bank’s long-term refinancing operations (LTROs) in late 2011 and early 2012 helped to increase lending and raise GDP from what it would otherwise have been. That is the conclusion of research by Matthieu Darracq-Paries and Roberto De Santis, presented at the Royal Economic Society’s 2013 annual conference.

The study looks at the effect of the LTROs, which allow commercial banks to borrow from the ECB at a fixed rate for three years in a bid to ease the credit supply in response to the growing sovereign debt crisis. The research assumes that the main way this helps the economy is by easing liquidity and funding risks for the banking system.

The study finds that the LTROs reduced the tightening of credit standards for lending to households and firms. By modelling what could have happened without the refinancing, the analysis suggests that GDP increased along with loans to non-financial corporations and individuals.

The refinancing also helped to reduce sovereign bond spreads in the first half of 2012 and acted against the bad news from countries such as Greece and Spain. Using bond spreads as a measure of interbank credit risk, it finds that the spreads declined from 100 basis points on the day of the LTRO announcement (8 December 2011) to 40 basis points at the end of March 2012 and despite fluctuating continued its declining trend by reaching 12 basis points in November 2012 – the same level as in August 2007.

The authors comment:

‘Our study brings an empirical contribution to research on the effectiveness of unconventional monetary policy at times of financial distress.

‘The quantitative findings show that in the presence of acute tensions, exceptional central bank liquidity measures can help to support the provision of bank lending to the economy and avoid an abrupt drying-up of credit supply.’

More…

In the second half of 2011, as the euro area sovereign debt crisis exacerbated, funding and deleveraging pressures on euro area banks raised the risk of credit supply disruptions affecting the financing of firms and households. Against this background, the ECB increased the length of the refinancing operations with fixed rate tenders and full allotment in December 2011 and February 2012 to three-years with the aim of supporting bank lending and counteracting the risks of a disorderly bank deleveraging process.

This study aims to assess the macroeconomic implications of the three-year long-term refinancing operations (LTROs) conducted by the ECB in December 2011 and February 2012, identifying the implied non-standard monetary policy shock through the Bank Lending Survey (BLS) information for the beginning of 2012.

The empirical analysis on the impact of the three-year LTROs assumes that the main transmission channel of this non-standard monetary policy measure works through the mitigation of liquidity and funding risks in the euro area banking system. This ultimately contributes to preventing a disorderly deleveraging process and supports the financing of the economy at large.

More specifically, the BLS suggests that non-standard liquidity measures have been successful in limiting the tightening of credit standards to households and firms due to liquidity risks and access to funding. This also supports the view that the three-year LTROs can be interpreted as a favourable credit supply shock.

Compared with the most likely developments one could have expected at the end of 2011 when financial tensions culminated, the model-based counterfactual experiments suggest that the three-year LTROs are expansionary and associated with increases in GDP and loan volume to non-financial corporations and a compression of lending rate spreads over a two-to-three year horizon.

The economic support of the non-standard measure is only gradually reflected in loan dynamics while the benefits for output materialise earlier. Moreover, given the moderate response of spreads compared with loans, the three-year LTROs are estimated to importantly act on the economy through quantitative credit easing.

Overall, this study brings an empirical contribution to the literature on the effectiveness of unconventional monetary policy at times of financial distress. The quantitative findings show that in the presence of acute tensions, exceptional central bank liquidity measures could help to support the provision of bank lending to the economy and avoid an abrupt drying-up of credit supply.

This assessment is consistent with the view that non-standard monetary policy measures like the one analysed in this study are complementary to interest rate decisions and are essentially predicated on the basis of emerging financial frictions in the credit intermediation sector.

The success of the three-year LTROs in reducing funding risk in the banking sector can also be demonstrated by the developments of the three-month EURIBOS-OIS spread in the first half of 2012.

Despite the renewed tensions in some euro area sovereign debt markets in the second quarter of 2012 owing to several country-specific factors, this measure of interbank credit risk declined from 100 basis points on the day of announcement (8 December 2011) to 40 basis points at the end of March 2012 and fluctuated around it since then until the speech on the convertibility risk by the ECB President Draghi on 26 July 2012.

After the speech, the interbank credit risk continued its declining trend, reaching 12 basis points on 26 November 2012. Such a low level was last obtained on 8 August 2007, the day before the ECB had to cope with the first signal of dislocation of the money market.

This money market resilience is consistent with the fact that bank funding risks were effectively reduced by the ECB measures announced on 8 December 2011, because the three-year LTROs provided a window of opportunity for banks to deleverage in a more orderly fashion and to increase their liquidity and capital buffers in a sustainable manner.

ENDS


Contact:

RES media consultant Romesh Vaitilingam:
+44 (0) 7768 661095
romesh@vaitilingam.com
@econromesh

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