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About a week ago, on March 27, a member of the ECB’s Executive Board, Isabel Schnabel, gave a highly informative speech titled ‘Back to Normal? Balance Sheet Size and Interest Rate Control’. It’s a fine description of the consecutive waves of ECB balance sheet expansions. The low inflation as a result of the EMU debt crisis prompted Draghi, as ECB president to provide targeted long-term refinancing operations to an indecisive banking system. Although geared to spur credit growth, this stable and dependable funding was often a source of attractive ALM transformation. This semi-conventional operation was quickly followed over Q1 2015 by a large-scale asset purchase program. The ECB, with a lag, closely tracked the FED blueprint. A massive second wave of balance sheet expansion got launched as a response to the pandemic. Another series of TLTRO’s and the Pandemic Emergency Purchase Program (PEPP) were the result and flooded the financial system with excess liquidity – bank reserves.
Excess liquidity in the European banking system is bound to drop forcefully over the next five years. Since a June 2022 ECB balance sheet high of EUR 8.8 trillion or 56% of the euro area’s GDP, its size has dropped by about EUR 1 trillion towards EUR 7.8 trillion. This drop came from the non-renewal of TLTROs, which fell from a high of EUR 2.2 trillion to EUR 1.2 trillion today. A condition of excess liquidity can disappear, in theory, by the end of the decade, with the ECB balance sheet falling to just below EUR 3 trillion. On the liability side, we would predominantly see banknotes in circulation, followed by required bank reserves and official sector deposits. On the asset side, we would capture Main Refinancing Operations (MRO) and Long-Term Refinancing Operations (LTRO), but above all, still a large government bond portfolio in run-off mode. The ECB bond portfolio was growing till end of February 2022. As of March, the ECB has dropped reinvestment by EUR 15 billion a month.
Is this trajectory realistic? No. Excess liquidity will be a permanent feature. Central bank balance sheets might remain bloated far beyond what we experienced pre-GFC. The main source relates to a steep drop in banks’ risk appetite and tolerance.
Regulators require banks to hold sound and solid Liquidity Coverage Ratios (LCRs) that translate into high levels of High-Quality Liquid Assets (HQLAs). Quantitative easing has made HQLA a scarce commodity (especially German Bunds). That is why balance sheet run-off will offer banks a growing pool of quality assets given the lack of ECB bond absorption. However, banks opt to hold onto excess reserves as a result of lack of confidence in a smooth distribution of reserves among banking institutions. The trust between banks has never recovered to pre-GFC levels given the fragmented quality of government bond assets that banks hold as long-term investments (Hold-to-Maturity assets). Another fear is that the level of overnight deposits as a % of overall deposits is about to shrink, as it did between 2005 and 2008, when that ratio dropped by 7 percentage points. Indeed, especially after the demise of SVB and Credit Suisse, deposit transformation into quality, segregated, short-term investment alternatives will rise. Also the general public asks questions that start with ‘What if my bank…?’
The central banks’ responsibility in safeguarding financial stability is as important as the responsibility of the banking system to manage and diversify their investment book correctly. Correctly as defined by first, not taking undue or too much duration gap risk in their ALM activities and second, preventing too much concentration risk in national government bond holdings. The age-old construction fault of living in an unfinished monetary union leaves the risk of rate fragmentation at uncomfortably high levels, with the presence of the Transmission Protection Instrument simultaneously being a threat and an attraction to speculators. Therefore, governments have to act responsibly across fiscal policy initiatives or lack thereof.
More generally, all actors need to attain responsible policies. The balance is fragile as risks related to:
The FED has decided to run a large balance sheet, effectively giving it a growth impulse by offering collateralised funding to the banking sector at a small cost (BTFP or Bank Term Funding Program). However, the FED also provides balance sheet access to non-banks, for money market funds run by asset managers, in the shape of the overnight reverse repo facility (ON RRP). The latter effectively pays a rate somehow less than what the FED pays to banks. A side effect of such a facility is that it disintermediates the unsecured money market functioning.
Coming back to the Schnabel speech, there is an interesting quote: “The uneven distribution of reserves within the system, together with the large uncertainty about banks’ underlying liquidity preferences, imply that central banks may have to keep a significant buffer of excess reserves in the financial system to avoid unwarranted interest rate volatility.” For sure, we have noticed over the past year that balance sheet run-offs put the financial system under pressure and inflict pain. Higher volatility across asset classes is evident.
At the same time, we sense that the current financial system requires high levels of excess reserves as banking becomes an increasingly complex, highly regulated business model.
Irresponsibility can have an outsized impact. The sector has a long way to go before balance sheet transparency feeds into lower risk premia. For instance, the road to parity on the price-to-book valuation metric in banking is long yet not impossible. Discount pricing is the rule. Premium valuations the exception. Then again, the past month made clear that not everyone bank will make it the moment on and off-balance -sheet constructions becomes too complex.
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