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Saturday, December 17, 2011

A misdirected bazooka!

Christian Noyer, Governor of the Banque de France, allegedly said the following in an interview with French news channel LCI: "What we decided yesterday in the governing council of the ECB was to use our bazooka ... so that banks can continue to do their job ... buy sovereign debt".

Headlines in other reports read like:  "Noyer – ECBs big bazooka will work through banks; ECB liquidity will encourage them to buy states’ debt”.

One of the more exciting aspects of these times is that one learns so many new things about the role of banks and the role of a Central Bank!

Perhaps not a very sophisticated but certainly an easy to understand description of the role of banks would be: they are intermediaries between those who have financial assets and those who need them. In this process, their role is to transform risks and tenors. 

Perhaps one of the more classic descriptions of the role of a Central Bank is that it is, among other things, a lender of last resort to the banking system. When it lends to the banking system as a lender of last resort, it requires first-class collateral such as highly-rated government securities. 

Traditionally, banks held highly-rated government securities in their portfolio for 3 reasons: (a) so that they always had enough collateral should last resort funding from the Central Bank be required; (b) for distribution to their customers who want to save in government bonds and/or for trading; and (c) for parking extra liquidity.

As a long-term investment per se, highly-rated government securities are not really that attractive for banks when the yield curve is flat (as it is now) because they have the lowest yield of all asset categories (see German bonds today). Even though they are freed from reserve requirements, they still blow up the balance sheet.

If I recall correctly, not so much time has passed since banks were accused for having done "reckless lending" to governments, thereby contributing massively to the current debt crisis in Europe. Some banks are already having to pay for that "sin" by having to voluntarily participate in the PSI for Greece.  

And now the ECB expects the banks to do more of that "sinning"? 

One ECB-logic could be the following: we give banks funding a near-zero interest rates so that they buy Greek bonds with high yields. In the process, they generate high margins and high profits which will strengthen their equity base. Somehow, I am reminded of a type of sub-prime logic.

Obviously, ECB funding is critically important to those national banking systems which are presently losing deposits in the billions. But if a, say, Greek bank takes funding from the ECB to buy Greek bonds which it subsequently pledges to the ECB as collateral, the funding base of that Greek bank has not changed a bit. The Greek bank may have contributed to the stabilization of prices for Greek bonds but --- is that the major role and/or responsibility of a Greek bank?

It will be interesting to see how Mr. Noyer's strategy plays out. It is certainly an interesting contrarian move: at a time when every bank tries to unload sovereign paper of deficit countries, the ECB offers banks incentives to buy even more of that. 

A traditional banker would say that this can never work but who knows? Many things in finance have been turned upside-down in the last couple of years. Perhaps it will work out, which would force the traditional banker to accept new wisdoms.

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