Window for ECB loan repayments nears

It’s payback time. On Friday, the European Central Bank receives its first indication of how much of the roughly €1tn of three-year loans taken out by hundreds of eurozone banks just more than a year ago will be repaid early. Now analysts and investors are fretting over how much money will be returned to the ECB and what impact, if any, it will have on markets.

The early repayment window officially opens at the end of January, giving banks the option to repay money borrowed under the ECB’s three-year longer-term refinancing operations once a week, every week until the LTRO matures.

The LTRO funds released in December 2011 and February 2012 averted a liquidity squeeze in the eurozone financial system, shoring up bank balance sheets at a crucial time in the debt crisis.

Early repayment of the loans should be a “good thing”, says Georg Grodzki, head of credit research at Legal & General. “It shows confidence in a bank’s business model and should alleviate concerns about banks being addicted to ECB funding.” That, in turn, should help bond issuance in ­public debt markets.

He says it will also help overcome fears that banks could “fall off a cliff” when the three-year loans reach maturity as lenders all rush at the same time to issue debt to replace money borrowed from the ECB.

Richard Comotto, senior visiting fellow at the ICMA Centre at Reading University, adds that those banks that do repay early will free up collateral pledged with the ECB – a move that could help revitalise short-term funding markets.

Much has been made of the loss of excess liquidity in the financial system and whether it will force short-term interbank overnight rates higher. But, based on early repayment estimates for the first quarter, ­analysts say the expected loss of liquidity would be unlikely to prompt a substantial increase in Euro overnight index average rates over the next few weeks.

With more than €1tn borrowed by at least 800 banks – half of which was rolled over from other ECB “open market operations” – the majority of analysts expect only about €100bn to €200bn of the LTRO to be repaid in the first three months of 2013.

The real importance of the early repayment figures lies in what it tells policy makers and investors about the health of the eurozone – and the divide between banks in the core and the periphery. Mario Draghi’s promise to do “whatever it takes” to save the euro and the launch of the ECB’s government bond-buying programme has reduced the tail risk of eurozone break-up, paving the way for a far-reaching markets rally.

Huw van Steenis at Morgan Stanley, says there has been a “sea change” in sentiment in the wake of central bank action: “Bank funding has reopened.”

Banks are tapping bond markets once again and their cost of funding has in some cases fallen to “the cheapest level for three years”. Some bank debt is trading more cheaply than investment grade credit for the first time in four years, Mr van Steenis adds.

Eurozone banks have moved from a position where many were facing a potential collapse of liquidity, to a point where there is strong international demand for bond issues from Spain, Italy, Portugal and Ireland.

What really counts is “who can repay and for what reasons”, says Marchel Alexandrovich, economist at Jefferies.

Northern European banks – many of which took the ECB loans as an insurance policy to protect against further shocks – are most likely to repay first as they take advantage of better funding conditions and seek to make better use of excess cash.

Commerzbank said it would repay early but other contenders include BNP Paribas, Deutsche Bank and Barclays.

But Carlo Mareels, banking analyst at RBC Capital Markets, says early repayment by banks in the periphery will be largely symbolic, because for most of them it is still much cheaper to borrow from the ECB at 75 basis points than tap public debt markets.

Southern European banks, the biggest users of the LTRO, could pay back as little as one-tenth of what they borrowed, says Morgan Stanley.

And while some banks are likely to pay back the LTRO early “to look good” or because they do not need it because of deleveraging, there is no real incentive to risk handing it back when banks might still need it, says Helen Haworth, head of European interest rate strategy at Credit Suisse.

She cautions that while there has been some stabilisation in markets, with those in the core seeing their funding costs come down, it is not the same in the periphery.

“Deposits have been returning but the system is still fragile and the potential for yields to go up again is still quite high,” says Ms Haworth

A sizeable repayment by northern Europe may have only a small impact on the market. But Jefferies’ Mr Alexandrovich warns that if Spain or Italy were to pay back too much it may be seen as a sign that they were “too optimistic” about the state of their banking systems and the wider economic environment.

“It is a misperception to think that the two [countries’] banking systems are overflowing with liquidity; the ECB’s money is still not making its way into the real economy.”