Saturday, January 26, 2013

Too early to celebrate ECB's balance sheet reduction

The ECB has been receiving praise for shrinking the Eurosystem balance sheet since last summer.
MarketWatch: - The euro notched an 11-month high versus the dollar Friday, as European banks prepared to pay back a larger-than-expected chunk of cheap, three-year loans provided by the European Central Bank.
Most of the reduction is from the MRO and LTRO loan repayments by EMU periphery banks. These were funds borrowed by banks to replace lost sources of funding, including massive losses of deposits.

Source: Credit Suisse

But before congratulating Mr. Draghi on this achievement, it is important to note that the ECB has simply swapped a portion of its on-balance sheet exposure for an unlimited off-balance sheet commitment via the Outright Monetary Transactions program.

Consider Spain for example. Fundamentals of the stretched financial system, collapsing property values, and record unemployment have hardly changed. There is certainly no fundamental justification for the spectacular collapse in sovereign yields (chart below), except for the fact that the ECB is committed to buy unlimited amounts of this paper should Spain request it.

Spain: government 2-year bond yield (source:

Just because off-balance sheet exposure is not visible doesn't make it any less real. As a reminder of how off-balance sheet exposures can quickly appear on balance sheets, just take a look at the start of the financial crisis in 2007. Large U.S. and European financial institutions had significant off-balance sheet exposures by providing backstop guarantees to their commercial paper vehicles prior to the financial crisis. When that commercial paper could no longer be rolled, banks, particularly Citi, RBS, and Wachovia, were forced to take assets - mostly mortgage securities - onto their balance sheets. The chart below shows mortgage securities on the balance sheets of large US commercial banks. This is not a "buying spree" in late 2007 to early 2008 - it's a forced balance sheet expansion driven by commercial paper backstops.

Large US banks' holdings of mortgage securities (source: FRB)

Now the ECB has this type of unlimited backstop to periphery Eurozone governments. And the recent stabilization of the EMU sovereign paper markets is driven entirely by the off-balance sheet commitment - which could easily turn into on-balance sheet exposure. Furthermore, any attempt by the ECB to exit this commitment will result in a complete reversal of these gains - and another Eurozone crisis.
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