Published on 27 January 2017

There is no end in sight to the low-yield environment around the Euro and all currencies associated with it. This is the meaning of the European Central Bank’s announcement that it is prolonging its Qualitative Easing programme. Even if the US starts to increase rates, this will not alter the ECB’s stance as the ECB would like to see the Euro fall against the USD to help Eurozone exporters, and an interest rate differential would serve this purpose.

The detail of the ECB’s Qualitative Easing programme points to the threat of a new European banking crisis. The ECB does not itself undertake the operations executed under QE or any other of its programmes: it has the other arms of the Eurosystem do that, i.e. the Eurozone National Central Banks (Bundesbank, Banque de France and so on).

Two types of operation broadly exist:
Firstly, Eurozone National Central Banks funding one another, meaning the ones that are the beneficiaries of capital flight lending the same money back to the sources of capital flight;
Secondly, Eurozone National Central Banks funding commercial banks in their own countries, because these banks have a big book of long-term loans to finance and cannot raise adequate funds in the interbank market, as well as which their retail deposit base is static or shrinking.

All Eurosystem operations must be collateralised, and herein lies the problem.

The collateral posted by the Italian central bank is Italian government bonds, the Banca d’Espana posts Spanish government bonds…, and Italian commercial banks offer loans to Italian borrowers as security, Irish commercial banks offer loans to Irish companies, most being secured on real estate.

The collateral has two important defects:
a. Correlation – the collateral carries the same credit risk as the borrower;
b. The collateral bears the same risks that blew up in 2008-11: mortgage-backed, commercial bank, and Eurozone sovereign.

Correlation is when Banca d’Espana offers bonds issued by its owner – the Kingdom of Spain – the source of funds for both being the financial capacity of individuals and businesses in Spain

The ECB programmes are essentially circular and aimed at keeping the system liquid – able to pay its obligations when they fall due by having debtors lend money to creditors only for the same creditors to pay the same debtors. No obligations are allowed to go “Past Due”, but the cost is an ever-increasing pile of IoUs issued by 23 or 24 countries in favour of 4 or 5 (Germany, Netherlands, err…).

So we have come no further forward from 2008-11 other than to exhaust the policy measures that governments and central banks can bring to bear, and create a mountain of IoUs.

If a new crisis materialises, it will inevitably bring another credit crunch as banks lose the capacity to lend, and this will be accompanied by the enactment of “bail-ins” of banks in accordance with the EU’s Bank Recovery and Resolution Directive: all depositors with more than EUR100,000 will lose the excess over that figure.

This prospect throws up an imperative on corporates – to review Cash Management policies and practices as a matter of urgency:
• Can more cash be squeezed out of the internal and external supply chain, to reduce reliance on bank credit?
• If there are surpluses of cash, how are they being deployed?
• What are the criteria regarding amounts being left in each bank?
• What other investment vehicles could be explored that do not involve European commercial bank credit risk?

There must be one strong caveat attached to this last point: Money Market funds and Special investment vehicles frequently have very high credit ratings because of the structuring around them and cushions of credit risk insurance and/or liquidity support – but they still invest in Bank Deposits and Bank Certificates of Deposit. As a result the investor has protection if prices decline by a certain percentage, and if a given percentage of investors want to redeem at the same time. But the percentages of cover are fixed. As regards credit risk, the percentage is unlikely to be adequate to fully reimburse the fund for value lost if the fund/vehicle has more than EUR100,000 invested in a series of banks that are all “bailed-in”. There would be an excess loss over the amount of cover which would directly reduce the value of investors’ holdings. Furthermore, if enough investors try to head for the exits, the liquidity support will prove inadequate and the fund will be compelled to close its doors to withdrawals, meaning the investment is no longer short-term and liquid.