The ECB as ‘liquidity monster’

Posted by Tracy Alloway on Sep 25 13:18.
An elegant note out from UBS analysts John Paul Crutchley and Alastair Ryan on Friday — discussing the perils of the European Central Bank’s liquidity ops.’
Here’s the crux of the problem, according to UBS:
In our view, the [European banking] sector faces a significant policy challenge to unwind the support mechanisms that have been put in place to stabilise the banking system. In particular, as we discuss below, there appears to be a substantial disconnect between the provider of liquidity in Europe (the ECB) which is supranational in fashion, and the regulatory apparatus that surrounds banks and remains wholly national.This has helped create a liquidity monster, with the ECB committed to provide ever-greater amounts of funding to the European banking system without any clear exit route.
That funding — part of the ECB’s “credit support” operations — is being used by the banks in the following ways, according to the analysts:
First, we see banks gaming the system through arbitrage; using ECB funding to raise profits by borrowing cheap money and presumably reinvesting this in higher yielding assets. Germany and Greece appear to fall into this category;
Secondly, we see banks where the level of ECB support appears to be becoming more structural. The Irish banks are those principally exposed to this, with ECB funding to that country representing over half the retail deposit base in Ireland. Norway also appears to be becoming more reliant upon the repoing of covered bonds with all recent issuance almost exclusively accounted for by usage of the government swap facility;
Thirdly, we see banks that have not been excessively reliant upon the ECB, but appear to be putting in place mechanisms to become more so. Spain stands out in this regard.
The danger, however, as that “liquidity monster” description should suggest, is that the ECB might not be able to reduce that reliance easily:It is clear that the regulatory debate in response to the crisis is still at a nascent stage. In the US, the political challenge lies in consolidation of the proliferation of regulatory bodies, a process that is likely to take some time. In the UK, the separation of roles and responsibilities between the tri-partite bodies is under active debate, with the electoral timetable almost guaranteed to ensure policy inertia. In continental Europe, we are witnessing the rather extreme outcome that results from having the provision of liquidity divorced from an ability to regulate banks.As a consequence, while the ECB worries about the banking system being increasingly reliant upon its short-term funding, it lacks any mechanism to encourage the banks to lessen their dependence upon it. As a result, bank reliance upon the ECB has continued to increase. In our view, the normalisation of funding represents one of the more significant challenges for the euro zone banking system. In contrast, the UK and US banking systems are in a rather different place.That reliance, incidentally, now looks like this:
More from the note in a bit.