Saturday, March 3, 2012

EONIA rate averaging due to the 3Y LTRO’s

Guest post by Kostas Kalevras 
(Twitter: @kkalev)

One of the reasons that an averaging provision exists for banks required reserves during a maintenance period is that it stabilizes the money market interest rate. In the words of the ECB:
The averaging provision implies that institutions can profit from lending in the market and run a reserve deficit whenever the shortest money market rates are above those expected to prevail for the remainder of the maintenance period. In the opposite scenario, they can borrow in the market and run a reserve surplus.
Banks run deficit/surplus in their reserve accounts to take advantage of the averaging provision
(the recent drop represents the ECB lowering reserve requirements)

It seems that the latest 3 year LTRO’s might allow a similar smoothing scenario to occur in the EOINA rate for longer periods. The latest MRO (7 day refinancing operation) was less than 30 billion € while the rest of the banks liquidity is provided through long-term LTRO’s, with more than 1 trillion € corresponding to the 3 year LTRO’s and most of the remaining amount in 1 year LTRO.

The problem is that interest on the refinancing operations is paid on the operation maturity. With MRO’s payments happened every week while the rest of liquidity was provided through medium term LTRO’s (1 and 3 months maturity). That made the MRO rates quite ‘sticky’ since banks had to earn most of the interest quickly in order to be able to pay it on operation maturity (the 2011 MRO’s were usually quite large in size).

Now almost all of the interest will need to be paid in more than a year from now, allowing banks to play averaging games with EONIA. Since liquidity is basically an asset of ‘Euro-core’ banks (which try to find risk free places to park it, lowering the SMP term deposit rate close to the ECB’s overnight deposit rate and basically only loan among themselves), the combination of excess liquidity and low needs to earn interest fast, works to push the EONIA to even lower grounds and remove spikes (the drop of required reserves to 1% from 2% also helped since the spikes occurred on the last days of each maintenance period) since the first 3Y-LTRO:

EONIA rate

On the other hand, periphery banks have to borrow using low quality collateral (something which increases the effective lending rate) from ECB, while certain banks (like Greek banks) have to use the ELA mechanism and borrow at 3.75% (and an effective lending rate of close to 4-5%). The end result is that ‘Euro-core’ has an ‘accommodating’ monetary stance with low lending rates and excess liquidity, while the periphery faces an effectively ‘restrictive’ monetary stance while it needs exactly the opposite.
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