On 10 March 2016, the ECB made a number of important decisions. First, it expanded its QE programme by about €20 billion a month, with the possibility to buy (investment grade) corporate bonds. The second is more of a real change.
The ECB has launched a new series of targeted longer-term refinancing operations (TLTRO II), which expands the previous TLTRO in two ways.
- First, it increases the amount of eligible loans that can be financed from 7% to 30%.
This concerns loans to Eurozone non-financial corporations and households, excluding loans for house purchase.1
- Second is the ‘cash for loans’ scheme, which is like a tiered interest rate in reverse.
The interest rate applied to the TLTRO II operations (with a four-year maturity) is equal to the standard rate (main refinancing operations rate) at the time of borrowing. But if the net lending of the bank rises enough (by end January 2018 it is at least 2.5% above a certain benchmark), the interest applied to the entire operation goes down to the ECB deposit facility rate. Since that is currently set at minus 0.4%, the ECB will, in effect, pay banks to lend money, in the sense that the banks would be paid by the ECB if they give out more loans. The total stock of eligible loans amounts at present to over €5,000 billion. In theory, 30% of this – or more than €1,500 billion – could be re-financed by this new scheme.
The TLTRO II could thus become important. But is it likely to reach the goal of incentivising credit for new investment? To answer this question we first analyse the benchmarks and the size of the incentive offered by this scheme and then show how the conditions to qualify for the cash from the ECB could be easily attained.
Measurement matters: Differentiated benchmarks
The most innovative element of this second TLTRO is its promise to subsidise loans if lending exceeds a benchmark. Formally there are two benchmarks; for those banks with positive eligible net lending in the 12 months before 31 January 2016, the benchmark net lending (until January 2018) is zero. These banks need to increase lending by 2.5% to get the negative rate. For those banks which had a negative eligible net lending in the 12 months before 31 January 2016, the benchmark net lending is equal to that figure. If one takes a bank with a loan book of €100 billion and a net lending, for example, of minus €4 billion over the last year, this bank would qualify for the negative rate once it reaches a negative lending of minus 1.5 billion (2.5% of €100 billion minus €4 billion).
The difference in benchmarks has a superficial plausibility. Banks whose net lending is negative might continue to contract over time. But this presumption does not correspond to the patterns one sees in reality. We performed a simple regression analysis with banks' growth in customer loans as proxy for net lending. We separated the cases of positive and negative loan growth and then checked within each group whether there is a significant relation between net lending in any one year, and the net lending in the following two years (because the benchmark is net lending until 2018). For the negative net lending group we find a significant negative relation. Hence, the banks with a net loan growth below zero in any one year are likely to have a positive loan growth in the consecutive two years. The result is significant at the 1% level. However, for the cases of positive net lending we do not find any significant relation with future lending.
- This simple result implies that the different benchmark for banks with negative net lending in 2015 might not be appropriate.
Banks that had negative net lending in any one year are anyway likely to bounce back with positive net lending in the following two-year period. This regularity from the past indicates that especially the banks with negative net lending are likely to receive the ECB premium, even if they do not change their lending policies.
It is also likely that this benchmark scheme may lead, de facto, to nationally differentiated monetary policy stances (or rather fiscal incentive schemes). In effect, the interest offered to banks is a function of past lending volumes and the lending pattern within each country tends to be highly correlated. Banks in countries where lending volumes had been contracting sharply recently would qualify for the -0.40% interest rate subsidy if they merely reduce the rate at which lending falls by 2.5% points.
The cash incentive
The incentive for additional lending could be substantial, if viewed against the entire life-time of the operation. For instance, a bank for which the benchmark is zero and which had €100 billion in eligible lending outstanding as of January 2016, could borrow up to €30 billion under the TLTRO II at zero interest. If this bank then extended an additional €2.5 billion of credit to non-financial corporations or households by January 2018, it would qualify for the lower interest cost on the entire amount it has outstanding under the TLTRO II (up to a maximum of €30 billion). Instead of ‘paying’ zero interest it would get annually from the ECB 0.40% on (up to) €30 billion in cash, or a maximum of €0.12 billion. As this will be valid for the entire lifetime of the operation (four years), the total subsidy would be (at most) €0.48 billion. Compared to the additional risk to its balance sheet of €2.5 billion – which the bank incurred in order to qualify for the interest rebate – this amounts to almost 20% (0.48/2.5).2
- The incentive provided by the ECB can be compared with the Juncker plan, which also provides a subsidy to investment, but on a project basis with a risk reduction of around 6.7%: every euro of EU capital put at risk was supposed to generate €15 of investment (= 6.7% first loss or equity).
There exists now a substantial list of investments to be financed, but it not clear to what extent this represents simply pre-existing projects, which have been re-jigged so that they qualify for this modest subsidy.
A cost of additional loans is, of course, that they require additional capital. However, this cost is always there and under normal circumstances is covered by the interest rate spread charged to borrowers. Window-dressing loans would also require more capital. This additional cost should be moderate; assuming a 50% risk weight and a capital ratio of 12%, banks would have to hold €60 million extra capital for each billion of extra net lending. Assuming a cost of capital of 10% per annum, the total capital cost would be €24 million over four years.3 In the example above, the total capital cost of ‘window dressing loans’ of €2.5 billion would be €40 million, a fraction of the interest rate subsidy of up to 480 million. Moreover, one has to keep in mind that actual aggregate net lending would need to grow much less than 2.5% even if all banks qualify for the interest rate reduction since for many banks the benchmark is a fall in lending.
- Given that this is the case for about one third of all banks, it follows that aggregate lending growth would not have to be much larger than the one observed until today (close to 1%) to allow most banks to benefit from the cash handout under the TLTRO II.
But the fate of the first TLTRO already showed that money is fungible par excellence.
The take up of the first TLTRO in 2014 exceeded expectation. But two years later one does not see any noticeable impact on investment. The reason for this is clear. Banks can easily window dress their loan book, for example, by handing out loans for ‘working capital’ under which the bank gives a loan at zero interest to a company which is then required to put the proceeds into a blocked account (possibly also at zero interest) as collateral. Moreover, banks can form groups (as allowed under TLTRO I). Within any group those banks just under the benchmark (+2.5%) could benefit from the net lending of others, which are much above the benchmark and thus qualify anyway for the interest rate subsidy. The real new credit may (again) only be a fraction of the total TLTRO borrowing.
Total outstanding loans eligible under the TLTRO II are around €5,500 billion (close to four times TLTRO I), implying that theoretically the total amount requested by banks could be up to €1,650 billion. From this sum one has to deduct the outstanding TLTRO (I) volume, leaving about €1,500 billion for the TLTRO II.
Under this hypothesis the total expense (or loss of seigniorage revenues for the ECB) would be about 0.40% of €1,500 billion, or €6 billion for four years, in total €24 billion. This is a considerable sum for the Eurozone banking system; and this perspective explains why banking shares jumped after the announcement. However, given that there is not necessarily a link between loans and investment, the ‘cash for loans’ scheme might have a very limited impact on the real economy.
Given the subsidy rate of about 20% calculated above the total amount of ‘incentivised’ loans (i.e. the lending which might not have materialised otherwise) would be about €120 billion.
- The hope of the ECB might have been that these new loans would correspond to additional investment or consumption which otherwise would not have been undertaken.
If this had been the case, the boost to demand would have been considerable, worth a bit more than 1% of Eurozone’s GDP.
- However, as shown above, it is unlikely that banks would actually finance new, risky projects when they can qualify for the cash without taking any risk.
This potential €24 billion of explicit interest rate subsidy would be larger than the €21 total EU funds committed to the Juncker plan. If one puts these two measures together one obtains a total of about €45 billion of public money committed to increasing investment. It remains to be seen whether all this funding will lead to a substantial amount of new investment.
Monetary versus fiscal policy
Finally there is the question whether subsidising loans over a specific period investment represents monetary or fiscal policy. The ‘cash for loans’ element in the TLTRO II is different from a ‘normal’ reduction in the lending rate which would apply to all new lending.
All monetary policy decisions have some fiscal implications because any lowering of the lending rate leads to a loss of revenue for the ECB (or, more precisely, the Eurozone) – unless the deposit rate is also lowered at the same time. Lowering the lending rate can thus have a direct impact on the so-called monetary income (in jargon, ‘seigniorage’) of the Eurozone that is then distributed via the national central banks to national treasuries. In 2014, the TLTRO I did not involve any loss of revenue since the rate was set at the normal refinancing rate plus 10 basis points. The Governing Council could have lowered the lending main rate on 10 March 2016 to minus 40 basis points. This would also have led to a large loss of revenue unless the deposit rate had also been lower to keep a difference between the two. Changing one or more of its policy rates would clearly be in the realm of monetary policy.
- Trying to influence lending decisions with a temporary subsidy is something which normally government do.
There is a close precedent for the TLTRO II in the form of the Funding for Lending Scheme adopted in the UK in 2012 which elucidates the border area between monetary and fiscal policy (see Alcidi et al. 2013 and Churm et al. 2015 for an evaluation).
From the outset, the Bank of England was aware that the Funding for Lending scheme was situated on the border between monetary and fiscal policy, leading to this official statement:
“The Bank has therefore sought and received an assurance from the Government that the objectives of the Scheme lie within its remit (as noted in the exchange of letters between the Governor and Chancellor on 13 July). And the Funding for Lending Scheme itself will be overseen by a joint Bank/HM Treasury Oversight Board, which will meet on a quarterly basis.”
In the UK, the conclusion was apparently that the Funding for Lending scheme was still in the grey zone between monetary and fiscal policy. A practical solution to represent the fiscal authorities was found in the form of a joint oversight board. Such a practical solution would de facto not be possible in the Eurozone as it would be unthinkable to have a joint Board with the ECB and finance ministry representatives (or perhaps on the Eurogroup Presidency) to oversee an ECB monetary policy instrument. But in reality the fiscal authorities should have been involved since the TLTRO II represents clearly a commitment of public (Eurozone) money – even more so than the Funding for Lending.
The ECB is testing the limits of its mandate by stepping into the fiscal policy space. Is this what a central bank should be doing? Even if the economic benefit is likely to be slim? The jury is still out.
Bank of England (2015), “Unconventional monetary policies and the macroeconomy: the impact of the United Kingdom’s QE2 and Funding for Lending Scheme” Staff Working Paper No. 542.
Churm, R, M Joyce, G Kapetanios, and K Theodoridis (2015), “Unconventional monetary policies and the macroeconomy: the impact of the United Kingdom's QE2 and Funding for Lending Scheme”, ECB (2016). Press Release, 10 March 2016.
Gros, D, C Alcidi and A Giovannini (2013), “Targeted longer-term refinancing operations: Will they revitalise credit in the Eurozone? European Parliament”, Policy Department A: Economic and Scientific Policy, European Parliament.
 Non-performing loans also count under the total eligible for the calculation. The small adjustment in interest rates also decided on that occasion appears of minor importance. The rate on the deposit facility was cut by an additional 10 basis points to -0.40% and the marginal lending facility (MLF) rate by only 5 basis points to 0.25%. The rate on main refinancing operations (MRO) reached 0%, after a cut of 5bp (from 0.05%).
 Moreover, the financing conditions of the TLTRO II contain an option element as the rate is fixed, but repayment is at the discretion of the borrowing bank. There is no mandatory early repayment anymore even if net lending falls below the benchmark.
 This is actually a maximum since the net lending benchmark is based on the stock as of January 2018, if some of the loans outstanding at this point in time are repaid earlier the additional capital would not be needed for four years.
 There are, of course, other, indirect fiscal implications through the link between ECB policy rates and the market for short-term government paper. But these indirect effects are not the key issue for the TLTRO II.