New ECB Rules Designed to Restrain Lending - Or Is It Only Window Dressing?

Tuesday, September 09, 2008

Having been a little off-guard during the European Central Bank's (ECB) press conference I have to come up with a postscript as new rules on collateral valuations were silently put on the website while ECB president Jean-Claude Trichet only talked about it at the end of the Q&A session on Thursday.
In its biennial review of its risk strategy the ECB created a new fifth category for ABS and established significantly higher haircuts (markdowns) towards the valuation of category 4 and 5 of so called tier 1 assets. According to the press release,
the risk control measures applied to marketable assets, a new liquidity category for marketable assets will be introduced (see Table 6 of the “General Documentation”). This new category IV will be composed of credit institution debt instruments (other than Jumbo and traditional covered bank bonds) that were previously part of category III. Old category IV will be renamed category V.
In numbers it means that all ABS except for German jumbo Pfandbriefe and covered bank bonds will undergo a haircut of 12% when taken on the books of the ECB. Using such collateral has become more expensive too. Check the latest details for all maturities and risk categories here and compare them with the earlier framework from July 2003 and the initial framework from 2000.

Haircuts and Markdowns
The new rules are a clear sign that the ECB will no longer accept shoddy collateral in bank funding. In addition to higher haircuts the ECB will also adopt a general 5% markdown before the haircuts are applied, said Trichet:
  • "As regards ABSs, we have decided to apply to asset-backed securities a uniform haircut of 12% for all residual maturities and all coupon types. So 12% across the board. I have to mention that we are not, then, increasing haircuts for all ABSs, because we had already applied a 12% haircut to some ABSs – ABSs with a fixed coupon and a residual maturity of more than ten years. And for ABSs with a zero coupon and such residual maturity – the haircut so far has been 18%. But it is true that for ABS with lower residual maturity, the Eurosystem is now increasing haircuts.
  • Still on the ABSs, we have decided to apply a haircut add-on to ABSs that are theoretically valued, in the form of a valuation markdown of 5%. The valuation markdown is applied to the theoretical price before the application of the 12% haircut. The total discount on the price is then exactly 16.4%, when you compute first the 5% and then the 12%.
  • On bank bonds, we have decided to apply a haircut add-on of 5% to unsecured bank bonds.
  • As regards close links in ABS transactions, we have decided to prohibit the submission as collateral of any ABS by a counterparty when this counterparty - or any third party that has close links to it - provides support to that ABS by entering into a currency hedge with the issuer or guarantor of the ABS or by providing liquidity support of more than 20% of the asset-backed security’s nominal value.
  • We have also introduced a new decision on the ratings, and we want higher rating disclosure standards. With regard to the External Credit Assessment Institutions, the so-called ECAI sources, the credit assessment must be based on a public rating. For ABSs, ratings must be explained in a publicly available credit rating report, being a detailed presale or new issue report, including inter alia a comprehensive analysis of structural and legal aspects and a detailed collateral pool assessment. So this involves the External Credit Assessment Institutions. Moreover, we would ask the External Credit Assessment Institutions to publish rating reviews for ABSs at least on a quarterly basis.

All this may be window dressing only, though. Let's take a look at the latest categories of so called tier 1 eligible assets.
  • Category 1: Central government securities and debts issued by central banks
  • Category 2: Local and regional government securities, Jumbo Pfandbriefe, supranational and agencies securities.
  • Category 3: Traditional Pfandbriefe, 
  • Category 4: bank securities, corporate securities
  • Category 5: All other ABS

These changes are designed in order to restrain banks from relying on ECB funding which has dramatically grown since the beginning of the credit crunch on August 9, 2007. But then again the bigger problem is the rating of all these securities. It was AAA-rated subprime MBS that created the ongoing market turmoil in the first place.

The ECB's Tap Is Still Wide Open
Ironically the ECB announced the unchanged continuation of its long term facilities at the same time as the new collateral rules. There will come another supplementary €125 billion with maturities in 2009, according to the release. In simple words, the ECB will continue to inflate until...
But they still do the anti-inflationary talk. ECB chief economist J├╝rgen Stark did a good reminder of what the ECB is supposed to do in this interesting speech from last Friday, hinting at increasing political interventions:
In the current challenging environment, maintaining price stability is both more demanding and more important than usual. Siren voices from various quarters ask that we subordinate this duty to other considerations. Such voices are becoming ever more voluble. In this context, the principles embedded in our monetary policy framework have been, I think, instrumental in ensuring that we stay the course.

A look at the weekly financial statement of the ECB shows it is high time to reduce the monetary expansion that is running lengths ahead of the contracting economy in the Eurozone. Trichet and his fellow Eurozone governors may have been spared an inflationary blow-off situation because of the strong correction in oil prices. But with producer prices running at an annual rate of 9% in the Eurozone, currently benign headline inflation of 3.8% can be strongly expected to pierce the 4% record mark soon again.
Given the geopolitical tensions this may have been a summer break only. Russia can be expected to tighten the thumbscrews if the European Union gets too cozy with the USA and its ideas of a missile ring around energy-rich Russia.
To round off my postscript on the latest actions of the ECB I want to point readers to Edward Hugh's excellent spaineconomywatch blog.
Scrutinizing central bank borrowing on a national level Edward alerts the world to the worrisome fact that Ireland's borrowing is actually ten times that of Spain when comparing the size of the two economies. In his own words:
...when we look at how this money lent by the ECB has been allocated, then even more eyebrows may be raised on learning that lending to the much castigated Spanish banks has been "only" running at around 49 billion euros (as of July), while lending to Irish banks reached 44.1 billion euros according to data from the Irish central bank in Dublin.
While all this leads to the conclusion that the recent weakness of the Euro has a very fundamental reason I nevertheless would not favor FRNs or Yen as an investment alternative. The dollar is broken and sees only a dead cat bounce these days. I note with pleasure that gold is slowly decoupling from all fiat currencies and even withstood the correction in oil prices. Remember the term "flight to safety?" 


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