ECB’s Rescue Plan: Will It Work?

12/22/2011 6:00 am EST

Focus: FOREX

Greg Michalowski

Chief Currency Analyst, FXDD

Greg Michalowski of FXDD explains the provisions of the European Central Bank (ECB) loan program and how it will affect troubled Eurozone banks and embattled nations like Italy, Spain, and Greece.

The European Central Bank (ECB) loan program whereby they will extend credit out to three years at the average of the ECB’s benchmark rate (currently at 1%) was subscribed to the tune of $645 billion. This was much larger than expected, but I am not surprised. 

With the ECB likely to keep rates low for an “extended period of time” (the Fed’s chosen words, not the ECB’s, at least publicly), the money represents virtually fixed liquidity at a low 1% yield or less if the ECB cuts more. Banks decided to take the money and run. 

So where can they run? That depends on who you are and how you are perceived by your fellow banks. If you are considered “at risk,” taking the money solves a liquidity problem. If you are not considered at risk, the money helps recapitalize your bank. There are other benefits to the “at-risk” economies like Spain and Italy, if the cards play out properly.

Below is how I see each of the sides shaping up.

Banks with Liquidity Concerns
Banks that have liquidity issues will be able to use the funds and not have to worry about securing funds in the interbank market. This will prevent a run on the bank should there be a worry about funding by depositors.

It also takes them away from the capital markets where they would likely have to pay a higher rate than 1% for three years. It buys these banks time to get their house back in order. 

Moreover, counterparties that are reluctant to lend to the troubled institutions now—even on a shorter-term basis—might be inclined to open up some lending lines to them. This is good and a sigh of relief for those institutions.

Banks without Liquidity Concerns
Banks that do not have liquidity issues can take the cheap funds and apply it in the market. For example, they could venture in the shorter-term debt market of Spanish and Italian notes—say, two years. Italy has a long-term credit rating of A2 from Moody’s and Spain has a rating of A1. It is not AAA, but it still is acceptable.

The two-year yield on Italian bonds is at 5.223% while the two-year yield on Spanish bonds is at 3.62% (see chart below). An average of the two countries comes to 4.4215%. Banks could purchase these notes with the 1% funds and earn carry profits of 342 basis points…not a bad return.

Click to Enlarge

Is this not similar to what the US banks did when the Fed embarked on their QE program (by the way QE2 was for $600 billion—very similar to the $645 billion today)? You bet.

When the Fed’s QE program was enacted, banks got the wink from the Fed that rates were to stay low for an extended time period, and they took the free money, invested in Treasuries, forced the yields down, and earned risk-free carry profits, which boosted capital. 

They paid off their loans from the Fed and are now in a better financial situation because of it. They could do this because the economy was deleveraging with little risk of inflation sticking. 



This is what the ECB may be looking to replicate as they force austerity measures (deleveraging) which will slow growth in 2012. The difference is the ECB can not embark on QE. They are looking instead for the banks to do the QE for them by giving them money, a wink that rates will remain low (and may even decline further) and in effect giving them the OK to buy Spanish and Italian debt.  Greece is a separate case, but manageable. 

Is that play risk free? No. MF Global found that out the hard way with their bet on Italian bonds.  However, the story has changed since the time of their demise, with the support from the ECB, the lowering of rates, and the likely scenario that rates will stay low for an extended period of time. 

It is too early to tell, but MF Global may have been a month away from hitting a home run on their risky bond position. The fact is, however, they were overextended at the wrong time, did not understand or define their risk, and when the run was on, they compounded their problems. 

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They also were the lone wolf on their bet. Others were concerned about the risk and getting rid of risky assets whether right or wrong. They went at it alone. It is never good to “tell the market” what to do. The market may not agree with your assessment. 

It is always better to “follow the market.” If the banks take the money and continue to invest in debt of the likes of Italy and Spain, it should turn the tide and take out even more of the risk premium.  Sentiment moves the market, and the sentiment may be changing.

So what are the financial gains? The down and dirty of taking $645 billion and earning a carry spread of 342 basis points in a relatively risk-free, two-year debt yields a return of $22 billion for year one, $44 billion for two years, and $66 billion for three years. It also should lower the cost of borrowing for the likes of Spain and Italy, which will allow them to roll over massive amounts of debt in 2012. 

Looking at the chart above, the borrowing cost in the two-year sector is already down over 200 basis points. Phew! That’s real money.

Banks are better off today. The likes of Spain and Italy (which are the main worries in the market) are better off today. Moreover, if they need to do more down the road, the ECB can simply do another tranche. 

The risk is that the liquidity will re-ignite growth, and with it, inflation. This is not likely, however, with the pressure put on austerity and the deleveraging that will likely continue to take place. If the economies do not deleverage, that will be a problem, but most think the opposite will occur. 

This is a good thing and likely the only thing that could have been done. The firepower has been enacted and the process is started. 

By Greg Michalowski of

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