Saturday, December 31, 2011

ECB, NCBs, and arbitrage yet again

Tyler Cowen posts again on the theory that banks are using the ECB's new and broader facilities for arbitrage by buying risky sovereign debt, thereby driving interest rates down.

There is another explanation for the fall in rates, see my comment below:

The new ECB collateral rules dramatically increase the quantity of assets that banks can submit to the ECB in order to get ECB clearing balances. Bank loans are now allowed, so are lower quality ABS. This means that it is less likely that the national governments will have to guarantee local bank debt. This was a real problem in Greece and Ireland, for instance, for the local banks had run out of assets to submit to the ECB. Instead, banks were creating debts amongst each other and having the government guarantee these debts, before submitting them to the ECB as collateral.

Since private non-marketable debt can now be submitted to the ECB, governments will no longer be required to covertly bail out their banks by guaranteeing intra-bank debts. That means that euro government debt is now a lot safer, and explains why yields are falling. So you can use an ECB arbitrage theory to explain the data, but there are alternatives.

Interfluidity also chimes in on The Eurozone’s policy breakthrough? My comment below:

I think the ECB’s policy change is designed to stop the intra-European bank run currently in effect, and not to support various governments. The arbitrage bit that Cowen is writing about is either a red herring or simply incidental.

Because of the Eoro area clearing & settlement mechanism, banks subject to capital flight need to submit collateral to their NCB on a continuing basis to deal with a bank run.

By lending settlement balances for three years and, more importantly, accepting lower quality ABS and bank loans as collateral, the ECB is committing NCBs to averting all degrees of bank runs from member banks. Hopefully this flexing of its muscles is enough to stop the run.

See this older blog post too.

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