ECB Balance Sheet Signals Sinking Quality of Credit Collateral

Friday, January 25, 2008

Rising tensions in the Eurozone banking system begin to show in the balance sheet of the ECB. Checking the latest weekly financial statement of the ECB one notes shifts in the asset positions that may indicate that the ECB is taking on more subprime collateral that would not be accepted in the regular repos.
While those positions where lower grade collateral can be hidden are growing at sometimes alarming rates, the Eurozone central banks have been salting away their best performing asset with undiminished fervor.
Doing Nothing Would Have Made Mega-Multi Profits 
A look at the asset positions of the ECB comes to a mixed conclusion. Due to the sale of hundreds of tons gold each year the Eurosystem has missed out on potentially more than €82.3 billion in profits. The Eurozone's gold hoard (Pos.1) could be worth €283 billion instead of the latest figure of €210.7 billion had central bankers only done what they have been doing in the fight against inflation: nothing. Eurozone inflation has been exceeding the ECB's target rate of 2% since last August. Money supply M3 has been out of control since the inception of the Euro, never falling below the target rate of 4.5% and remaining at a record growth rate of 12.3% in the last 2 months.
This results in a dramatic explosion of the total volume of the balance sheet which blew up by more than 30% since Dec 30, 2005 and now stands at €1.35 trillion. It is interesting to see that the Eurozone economy, limping along with economic growth rates in the 2% area, needs 16% more ECB credit every year since 2006. Is real inflation closer to 14%?
A look at total money market lending results in positive surprise, at least on the surface. Banks had borrowed €459 billion last week (Pos.5), essentially the same as at the end of 2006, when the volume was €450 billion. But that is still 10% more than at the end of 2005. These figures confirm ECB president Jean-Claude Trichet's stance that monetary policy is still accommodating.
Other asset positions clearly show that funding is very easy to get. The stabilization of money market volumes may also be interpreted that Eurozone banks are running out of prime collateral, especially when seen in connection with those asset positions where lower grade collateral may be hidden.
Claims on non-Eurozone residents (Pos. 3) show a sidewards trend with €141 billion at the latest count.
Forex claims on Eurozone residents (Pos. 2) shot up 58% to €37 billion since the end of 2006. These are the Federal Reserve Note repos transacted by the ECB in December.
Euro claims on foreigners (Pos. 4) rose a bit less but still stand with €15 billion more than 22% higher than at the end of 2006.Then comes the first black box. So called "other claims" on Eurozone banks (Pos. 6) have grown more than sevenfold in the last two years, shooting from a mere €3.6 billion to €30 billion by last week. According to the ECB's explanation, "the position securities of euro area residents denominated in euro contains certain categories of marketable securities, which may potentially be used for monetary policy operations." That can be anything.
Euro denominated securities of Eurozone residents (Pos. 7) had seen a dip to €78 billion by the end of 2006 and stand now with €97 billion €5 billion higher than at the end of 2005. The ECB's glossary lacks a closer explanation of this position.
Public debts monetized by the ECB show a slow downtrend, falling €2 billion to €38 billion in the last 2 years.
My worries focus on "other assets" (Pos. 9.) This trashcan has ballooned by 128% from €145 billion to €332 billion since the end of 2005. The position other assets is a collective item including, in particular, items in the course of settlement (settlement account balances, for example the float of cheques in collection), coins of euro area Member States and other financial assets (e.g. equity shares, participating interests, investment portfolios related to central banks' own funds, pension funds and severance schemes or securities held due to statutory requirements). This item also contains tangible and intangible fixed assets, revaluation differences on off-balance-sheet instruments as well as accruals and deferred expenditure.
Again, that can be any kind of paper debt, valued at the discretion of the ECB. For my part, I feel uncomfortable with this long term trend in declining asset quality that may show that the banking system may be broken beyond repair. Is this the beginning of the end of the Euro? I am tempted to take bets.


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