The Big Bertha was one of the largest cannons of its time, manufactured by Krupp. Germany nevertheless lost the First World War.
The same might be true for the ECB and its version of the “Big Bertha”. In December and February, the ECB lended about one trillion Euro for three years to banks in the Euro zone.
One tacit motive of the “Long Term Re-financing Operation” (LTRO) – nicknamed after the Krupp howitzer by nobody less than Mario Draghi – was to prop up the Euro zone’s stricken sovereign bond market.
Instead of directly buying more bonds on the secondary market, the central bank took a detour via the financial system.
It lent to private banks who were thought to use the money to buy governments bonds. This deal promised to be very profitable for the banks: Italian and Spanish bonds offer yields of five percent or more while the LTRO loans only cost a meagre one percent.
At first sight, the ECB’s idea has worked. According to the May monthly report of the Bundesbank (released on Wednesday, but unfortunately currently only available in German), there is “clear evidence” that the banks used the LTRO money to buy mainly government bonds.
Hence, in the first quarter of 2012, the “Big Bertha” resuscitated the lending of private banks to sovereigns, the Bundesbank asserts. According to figures presented in the monthly report, the loans of private banks to Euro zone governments increased by 100.5 billion Euro.
Compared to 2011, this is a remarkable change. Last year, the lending by private banks to sovereigns stalled. In 2011, the net inflow of bond loans by financial institutions amounted to 149 billion Euro. However, according to the Bundesbank, this money came entirely from the ECB, who bought government bonds on the secondary market in 2011.
So far, so good. The “Big Bertha “really was a game changer.
However, its firepower seems to have some serious side effects that might make matters worse from a medium term perspective.
The LTRO operations seem to have reinforced the dangerous link between weak banks and the overly indebted governments in the periphery of the Euro zone. According to the Bundesbank, the increase of sovereign bond purchases by private banks in the first quarter was mainly caused
“by Spanish and Italian banks who almost entirely bought sovereign bonds of their domestic government”.
This is really bad news.
One fundamental problem in the Euro zone is that there is a vicious circle between weak banks and weak sovereigns. Financial institutions in countries like Greece and Spain are looking into the abyss and urgently need a hand from the taxpayer. Simultaneously, the calamities of the banking sector fuel the mistrust in the solvency of governments in Spain and other countries in the periphery. On top of this, banks bought too much debt issued by their local government.
This leads to a vicious circle, as a team of economists around Princeton’s Markus Brunnermeier point out:
“European banks [took on] excessive exposure to their own sovereign credit risk. This led to a diabolic loop whereby sovereign risk and bank weakness reinforced each other – in countries where sovereign debt was perceived to be riskier, bank stocks plunged, leading to expectations of a public bailout, further increasing the perceived credit risk in government bonds”
The LTRO seems to increase the exposure of European banks to the bonds of their home government. Instead of breaking the vicious circle, it might have been reinforced. More outright purchases of government bond by the ECB – strongly opposed by the Bundesbank – would have been the better alternative to the “Big Bertha”.
Currently, the Euro zone’s banking sector might be at risk to be killed by friendly fire.