Coronavirus emergency, the "blunt" moves of the ECB (and why the markets didn't like them at all)

March 13, 2020

Lea Zicchino, Lorenzo Prosperi

The ECB is moving to support the Eurosystem economy by launching a series of extraordinary new measures, but without cutting interest rates. For the first time there is a coordinated decision on monetary easing and prudential requirements, from which banks will benefit. But for the financial markets it has not been enough

 

According to the European Central Bank, the crisis generated by the Coronavirus will lead to a generalised contraction in output and a reduction in domestic and foreign demand. The new package, the first of the Lagarde era, is aimed at supporting families and businesses through favourable financing conditions to preserve the transmission of credit to the real economy. The new set of measures announced, voted unanimously by the Governing Council of the ECB, is made up of several points.

  1. 1) Unchanged monetary policy rates. This is understandable in a context where a further reduction in short-term rates would only have had a marginal effect on financial conditions and the exchange rate. The other central banks have much more room to cut rates.
  1. 2) More favourable conditions on TLTRO auctions. One of the most important measures launched today by the ECB to support the sector most sensitive to the Coronavirus emergency, i.e. small and medium enterprises. The TLTROIII between June 2020 and June 2021 will have the following characteristics: a) banks will now be able to request a higher maximum amount, up to 50% of the stock of loans eligible in February 2019 (from the previous 30%); b) a benefit of 25 basis points on the rate of TLTRO III, which translates into -0.25% for banks that will not exceed the target funding to businesses, and up to -0.75% for those who exceed them; c) conditions on the achievement of the most favorable targets (minimum credit growth rate at 0% instead of the previous 2.5%). This means the Italian banking sector has the possibility of obtaining up to EUR 470 billion, with a maximum benefit for banks of around EUR 3.3 billion.
  1. 3) Weekly LTRO auctions until June 2020. This measure represents "an immediate injection of liquidity to support the financial system", to quote Lagarde. The interest rate of the LTROs will be equal to the average rate on deposits (-0.50%), obtainable without reaching any funding target.
  1. 4) Increase of EUR 120 billion in the asset purchase programme until the end of the year. Quantitative Easing will continue as long as "necessary" to reinforce the accommodative impact on interest rates. The amount of monthly purchases will increase by EUR 20 billion to EUR 32 billion per month, numbers below analysts' expectations. In addition, the ECB has not announced an adjustment of issuer-specific purchase limits, as new purchases should be concentrated mainly on private sector securities.
  1. 5) Loosening of prudential requirements. As mentioned above, this is the first time that there has been coordination between monetary and prudential policy measures. The SSM allows banks to make full use of capital buffers (Capital Conservation buffer, Countercyclical capital buffer and Pillar 2 Guidance, P2G). In addition, the composition of the Pillar 2 requirement (P2R) anticipates the CRD5 measures, which would come into force in January 2021, allowing banks to meet the requirement also with Additional Tier 1 and Tier 2 instruments. All this allows "significant" Italian banks to release around EUR 43 billion of Risk Weighted Assets to ease supply constraints and support credit to households and businesses. In particular, if these volumes were to be used entirely to finance businesses, there would be about EUR 75 billion of new credit (considering an average risk weight on these exposures of 55%, based on Transparency Exercise data). Finally, the ECB will grant operational flexibility in the implementation of bank specific prudential measures and has postponed the stress test exercise to 2021.

A greater contribution to credit growth could stem from the introduction of public guarantees, which would allow for less capital absorption of credit: something that the ECB hopes can be introduced by governments.

However, markets immediately reacted very negatively to the package of measures. This may be partly explained by the failure to cut rates or by a lower than expected increase in the securities purchase programme. By now the markets have must have realised that the monetary policy toolbox is pretty empty, making coordination with fiscal policy even more fundamental. Christine Lagarde's continuing appeal to Member States' governments to implement "immediate, ambitious and coordinated" fiscal measures to support the eurozone economy, in order to make the central bank's accommodative policy effective, was the key signal that unleashed one of the most massive panic sales in financial history.

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