Wednesday, January 11, 2012

The ECB's exclusive party

I came across this chart from Bank of America/Merrill Lynch showing how central bank balance sheets have expanded

The report states that balance sheet expansion does not necessarily represent quantitative easing, but the result of liquidity operations such as LTRO:
The ECB’s balance sheet quietly reached a record size of €2.7tn in late December, with a growth of over 40% in the past six months. Both the size and pace of the balance-sheet expansion have attracted the market’s attention since the start of 2012. Questions have been raised as to whether such an expansion should be regarded as quantitative easing or not. We highlight below that the ECB’s bond purchase program was not the major driver of the expansion but that, instead, increased bank borrowings played a more important role. Also, we note that unlike the Fed, the ECB does not have full control over the size of its balance sheet. The latter could continue to grow in the coming months but it could also shrink on lower reserve requirements and improved funding conditions.
Such liquidity operations they are. Joseph Cotterill at FT Alphaville pointed out that banks can now get instand and unlimited liquidity by issuing themselves unlisted bonds and then use those bonds as collateral at the ECB:
[W]e said the ECB’s decision in September to accept unlisted bank bonds — i.e., bonds that the banks could have issued purely to themselves solely in order to pledge them as collateral for central bank funding — was “potentially very significant”.

Is this an exclusive party, by invitation only?
It's obvious by now that the ECB is throwing a liquidity party. What's more significant, like the Sherlock Holmes story about the dog that didn't bark, is that we haven't heard a thing from the Germans despite the rapid expansion of the ECB balance sheet and tsunami of liquidity unleashed on the market.

The effect of this liquidity pump has been to support European banking system. A look at the Euro STOXX 600 Banking Index shows that, despite Unicredit's well-known troubles with its share price, the index is testing a critical support level.

These developments begs a couple of questions:
  1. Are European banks a screaming buy at these levels? The extraordinary intervention of the ECB has taken the risk of a catastrophic banking failure off the table.
  2. Why aren't there more institutions at the ECB's party? The last LTRO auction saw 523 banks at the ECB's party. In the wake of the Lehman Crisis, the Fed's liquidity dump saw everybody and his brother turn themselves into banks to feed at the Fed and the Treasury's troughs. In today's Europe, why haven't we seen more institutions of financials and near financials, e.g. Allianz, Munich Re, the finance arm of auto companies, brokerage firms such as the European operations of Goldman Sachs, even hedge funds, etc., turn into banks to avail themselves of cheap LTRO money? Is the ECB throwing a highly exclusive party, by invitation only?
The answer to question 1 depends on the answer to question 2.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


JGW said...

good question, but what say you?

Cam Hui, CFA said...

I honestly don't know the answer. It's a puzzle to me.

Beno said...

Humble Student
Just a quick note to say been following you for a while and I appreciate your thoughtful articles. Keep up the great work. Cheers.