Euro Banks Tank as ECB Tightens Rules on Liquidity Facilities

The ECB, like the Federal Reserve, implemented bank liquidity facilities which (in oversimplified terms) allow them to pledge collateral in exchange for cash. The ECB has been more liberal in the types of collateral that it accepts, which has led to some pretty blatant gaming of the system (and God only knows how much slippery behavior at the margin).

The ECB decided it had had enough, and “refined” its rules a tad, airly noting it shouldn’t affect much collatal. The markets took a rather different view and banking stocks beat a hasty retreat, even though the changes do no come into effect until February 1 (not surprisingly, after the widely-anticipated year-end liquidity squeeze).

From the Financial Times (hat tip reader Marshall):

Bank stocks in Europe and the UK fell sharply and the risk of owning their debt leapt on Thursday after the European Central Bank declared a crackdown on abuses of its bank liquidity operations…..

Mr Trichet announced a series of measures to increase the cost of using asset-backed securities to obtain ECB funds and to exclude some such deals when underlying mortgages or other loans are not denominated in euros…

This year it emerged Macquarie Bank had constructed a deal backed by Australian car loans that could be used at the ECB and Lehman Brothers had formed a huge collateralised loan obligation of risky buy-out debt to use at the central bank.

Mr Trichet said the “general character” of its broad-based operations remained unaffected. “We’re not changing it, we’re refining it,” he said.

Only a “small fraction” of collateral would be affected. Banks’ ability to take part in its financing operations would be unimpaired, the ECB president said.

Analysts said the changes would affect banks sharply. “[It is] a further squeeze on banks, increasing the pressure on them to do more expensive longer-term funding … when there is already investor concern about … their existing refinancing needs,” said Matt King, credit strategist at Citigroup.

UK banks saw the biggest share falls with HBOS down almost 7 per cent at 282.5p, Barclays down 6 per cent at 336.96p and Lloyds TSB down 5.7 per cent at 288.9p. The worst-affected European banks were UBS of Switzerland and some smaller regional banks such as Erste Group of Austria and Piraeus Bank of Greece….

The changes, which take effect from February 1, include increases in the average “haircuts” applied to asset-backed securities. A haircut is the amount deducted from the market value of a product when judging its value as collateral. In future, a blanket 12 per cent haircut will apply, replacing a previous sliding scale of between 2 per cent and 18 per cent. There will be penalties for asset-backed securities valued using models and for unsecured bank bonds.

Restrictions already in place on banks using assets they themselves had formed were extended to stop banks using assets from issues to which they had offered currency hedges or liquidity support above a certain level.

Analysts at Barclays Capital said the extra haircuts would mean banks might have to post an additional €25bn-€45bn of securities for collateral purposes. “That could cost €375m to €450m annually to banks … Not in significant, but probably bearable,” said Laurent Fransolet, analyst at Barcap.

Update 12:30 AM: Willem Buiter provides a detailed discussion. His conclusion:

Two things are clear. First, much more will have to be done to clean out the Augean stables of the EU collateral universe. Second, nothing serious will happen until the current financial crisis is history. Stable-cleaning measures will tighten credit and worsen liquidity conditions in unpredictable ways. Now may not be the right time for a great leap forward towards the first-best. Even the minor tinkering measures announced on September 4 won’t become effective until February 1, 2009. So go for it, boys and girls. Repo your rubbish while you may!

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  1. Observer

    Don’t know how to send you email, Yves, to suggest a headline item, so this will have to do: am I the only one who is freaked out about the rapidly strengthening dollar (coupled with oil in freefall for at least a short while more)? Given how everything is crosswired between FX and a gazillion derivative flavors but especially CDS in the unregulated frontier markets, and then tied back to approximately-real assets (what Bill Gross quaintly calls “delevering”), it’s not even so much the direction but the rate-of-change that is worrisome.

  2. Ginger Yellow

    “In future, a blanket 12 per cent haircut will apply, replacing a previous sliding scale of between 2 per cent and 18 per cent.”

    It’s important to realise that the vast majority (I’m talking 95% plus) of ABS submitted to the ECB had the 2% haircut. The sliding scale only applied to fixed rate/zero coupon securities, and almost all euro denominated ABS is floating rate.

    My take on this is that it’s pretty much the least they could do without keeping an obviously and dangerously outdated regime in place. They haven’t really touched the rating requirement, they have to a certain extent limited counterparty risk, but they haven’t banned any asset classes or really prevented “abuses” of the system by non-Eurozone banks. That said, I’m in favour of allowing non-Eurozone collateral, but it should be reciprocated by other central banks. ECB liquidity has been a valuable means of improving investor demand for some ABS issues. Far better that Australian banks, say, are issuing in Europe than turning to the RBA instead.

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