Europe's Lender of Last Resort !!

The origin of central banking dates back to the establishment of the Swedish Riksbank and the Bank of England in the seventeenth century.


These institutions were created with the purpose of providing currency and funding their respective governments’ debts and hence central banks earned the title of “lenders of last resort”. Tasked with this function, central banks were able to stabilize the real economy during events such as extreme weather, banking runs, wars and other panic driven situations. In the aftermath of the financial crisis of 2008, central banks around the world returned to their roots and provided funding to their governments via the unconventional policy known as quantitative easing.

Established by virtue of the Maastricht Treaty, the European Central Bank (ECB) is prohibited from large-scale financing of European sovereign debt. A hallmark of the Bundesbank, this restriction disarmed the ECB in their response to the euro-zone sovereign debt crisis that threatened to destabilize the European monetary union. As an alternative to direct quantitative easing, where a central bank drives government bond yields lower by purchasing bonds from banks, the ECB engaged in their own unconventional monetary policy measure known as Long Term Refinancing Operations (LTRO).

Under the LTRO programme, European banks were provided with the opportunity to obtain three year financing from the ECB at 1% against a wide array of collateral. The perceived outcome was that banks would force government bond yields lower by buying the sovereign bonds at yields in excess of 7% and pledging these bonds as collateral in the LTRO programme to obtain funding at 1%. In turn the liquidity available to the banking sector would reduce the funding pressures faced by the banks themselves.

In two iterations of the LTRO, in December 2011 and February 2012, European banks borrowed a total of around € 1 trillion. While much of this amount was used to retire other debt obligations and will not reach the real economy, the dramatic fall in Italian bond yields since the introduction of the LTRO served as a buttress for the ECB’s latest crisis fighting measure. Key to understanding the impact of the LTRO is that such measures act only to alleviate funding problems arising from liquidity constraints and not solvency constraints.

The increased liquidity in the European banking sector has contributed to the flow of funds into South Africa, with around R 17 billion of foreign money finding a home in the local bond market this year. The positive sentiment generated by the LTRO is also clearly reflected in the local currency with the rand strengthening by around 90 cents against both the US dollar and the euro since the launch of the first three year LTRO.



Ultimately, while the LTRO cannot be viewed as a panacea for the problems faced by the euro-zone, the provision of liquidity has bought time for Europe to solve the underlying issues of productivity, competitiveness and solvency by reducing the probability of tail-risk events such as bank failures triggered by a credit crunch.

REF : Ruen Naidu PSG



 
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