What Are TLTROs? And How Will They Affect ECB Monetary Policy in 2022?
(8 min read)
(8 min read)
The Eurosystem comprises the European Central Bank (ECB) and the Eurozone (EZ) member central banks. It provides liquidity to the financial system via open market operations (that is loans to banks). These regular lending operations have historically been covered by one-week main refinancing operation (MRO) and three-month longer-term refinancing operation (LTRO) lending.
Targeted longer-term refinancing operations (TLTROs) are a form of non-regular, longer-term lending that the Eurosystem has offered to banks since the ECB took the deposit (depo) rate negative in June 2014. Since then, there have been three tranches of TLTROs. Each offer far longer maturity loans (up to four years) at much cheaper rates (Chart 1).
To understand the purpose of TLTROs, we should first understand how banks make their money. In very simple terms, banks lend out long term and borrow short term (from the ECB, and via firm/household deposits). As long-term interest rates tend to be higher than short-term, they pocket the difference (the ‘client margin’) as profit (we have written in more depth on the EZ banking sector previously). In other words, their profit margins are driven by the ‘steepness’ of the interest rate curve.
The issue is that since the Global Financial Crisis (GFC), the interest rate at which EZ banks have lent has declined. Meanwhile, the MRO lending rates (from the ECB) and, to a large extent, household deposit rates have been floored at 0% (banks are generally reluctant to charge households for their deposits). The more negative rates go, the worse this situation gets.
This issue of declining client margin is that, at best, banks may no longer be incentivized to lend so much to the economy. At worst, the financial security of banks may deteriorate. Central banks cut interest rates to ‘loosen’ lending conditions. But if a cut disincentivizes bank lending, then in actuality it will ‘tighten’ them. This is the concept of the so-called ‘reversal rate’.
The reversal rate comes about as negative rates disincentivize banks from lending more. TLTROs were designed to resolve this problem by providing lending to banks at even more negative interest rates (as low as -1.0%). But the catch was that banks had to use the money to finance lending to the real economy (i.e., loans to non-financial corporates and households excluding mortgages). Banks are allowed to borrow via TLTROs up to a fixed percentage (currently 55%) of their book of these loans.
TLTRO usage reached €2.2tn in June 2021 (Chart 1). It is, however, difficult to determine exactly how much lending TLTROs have directly incentivized.
The ECB suggests that the 2020 surge in TLTRO usage may have incentivized a direct rise in lending of around 5%. The ECB is pretty unequivocal that it has been significant, particularly through the Covid period. TLTROs have replaced a good portion of the need for banks to borrow in the market. And in doing so, the ECB claims, they have lowered the cost of bank funding and therefore avoided the potential rise in loan interest rates.
However, again, the scale of this is hard to tell. The ECB has been buying bonds (albeit not financial institution bonds) as part of its various asset purchase programmes through much of the period since TLTROs came about. That has helped to keep corporate and financial firm bond interest rates relatively low (Chart 3).
TLTRO III encompasses the majority of outstanding TLTRO lending. For TLTRO III, there is a relatively convoluted calculation of the interest rate dependent on lending rates.
In simple terms: the maximum interest rate is the average of the MRO (currently 0%) over the lifetime of the TLTRO, except in the period June 2020 to June 2022 when it will be MRO less 50bps. However, if lending thresholds are met at certain times, the interest rate can be as low as the average depo rate (currently -0.5%) over the bond’s lifetime, except in the period June 2020 to June 2022 when it will be depo less 50bps.
This means that banks are paying between -0.5% and -1% for their TLTRO borrowing right now (functionally, they are being paid between 0.5-1% to borrow). After June, they will pay at best -0.5% for the borrowing, but with this figure attached to future ECB interest rate policy – i.e., if interest rates rise, the cost of the borrowing will rise for TLTROs held after this June.
The most attractive terms of the TLTRO end on 23 June 2022. Therefore, banks will be increasingly tempted to re-pay the TLTRO then (they have the option quarterly). While the TLTRO III loans begin to mature in 2023 (Chart 1), this could mean a greater proportion of repayment before then (particularly if the ECB raises the depo rate anywhere near as quickly as the market is pricing).
TLTROs have helped to incentivise banks to lend more and cheaper to their customers by lowering the cost of bank funding. Meanwhile, as banks have needed to fund themselves less in the market (by issuing bonds) than they would otherwise have had to, the total supply of bonds has been reduced. Less supply means a higher price for these bonds, and with it, lower interest rates.
As TLTROs become less attractive, and are possibly repaid, the opposite effect will happen. The cost of banks to finance themselves will rise, and borrowing in general will become more expensive.
We can see the effect TLTROs have had on bank financing by looking at excess liquidity (the liquidity banks hold above their needs) and inter-bank lending rates. TLTROs have significantly increased the excess liquidity in the banking sector. Excess liquidity is typically parked on deposit at the central bank, lent within the ‘inter-bank’ market (i.e. to other banks short-term), or used to buy highly liquid sovereign debt. In this regard, the more excess liquidity in European banking, the tighter the interest rate on inter-bank lending (EURIBOR) has been to the depo rate (Chart 5). EURIBOR rates are already rising fast above the depo rate due to expectations for an ECB rate in July. A reduction in excess liquidity could add further upward impetus.
Meanwhile, as mentioned previously, banks will need to replace the financing that TLTROs provided. The European Banking Authority (EBA) estimates that European banks will need to significantly increase borrowing in the market in 2023 to offset TLTRO maturities; early repayment from June 2022 would bring this effect forward. This will increase the supply of bank bonds in the market, and with it raise the interest rates that banks and other corporates need to pay to borrow in the market.
The end in attractive TLTRO conditions in June will coincide with the ending of ECB asset purchases. And it will likely immediately precede the ECB raising its depo rate (currently on track to come in July). This means that the ECB will be tightening credit conditions by three different levers all at the same time, some of which may exacerbate the effect of one another.
Raising the depo rate will raise the interest rate of short-term borrowing, while ending asset purchases will raise the interest rate of longer-term borrowing. Meanwhile, as noted previously, TLTRO repayments, the decline in excess liquidity and the higher bank financing costs will both raise the cost of short-term borrowing (in the interbank market) and raise the cost of long-term borrowing (by necessitating more bank bond issuance). Because many of these ‘ultra-easy’ measures have never really been wound down to this degree, and certainly not all at once, the ECB may have a harder time keeping track of how much tightening they are introducing, which may make them more cautious if the economy does slow.
The offset to this is that as TLTROs dampen the ‘reversal rate’ effect (explained above), the end of attractive terms in June will make it more imperative for them to end the negative depo rates policy too. In this way, to a degree, they may find their hands tied with regard to tightening even further.
Banks have borrowed around €2.2tn in TLTRO III loans since September 2019, with the majority borrowed in June 2020 (€1.2tn). If this has, on average, paid around 0.5% to them, it suggests a total P&L gain of around €10bn pa. While that accounts for a decent chunk of Eurozone bank bottom lines, the rising interest rate environment should more than offset this (see here for our analysis of the banking sector).
With the early payment (likely picking up from June 2022) and eventual maturity (predominantly in June 2023) of TLTRO loans, Eurozone banks will need to find alternative sources of funding to balance out their assets. For the most part, the EBA expects this will come in the form of borrowing in the market (bond issuance) to cover the shortfall (Chart 5).