Moody’s expects European banks to prolong their borrowing under the European Central Bank’s (ECB) main liquidity support program (the Targeted Long Term Refinancing Operations, or TLTRO) by a year as a result of the ECB’s decision to raise interest rates. Moody’s initially expected the sector to start repaying its TLTRO borrowing from June 2022. This is because the current exceptionally low TLTRO borrowing rate is due to realign with the ECB deposit rate on 23 June, closing off the opportunity for banks to make profits by redepositing TLTRO loans with the ECB. However, pre-announced rate rises in July and September 2022 will keep the TLTRO rate below the new deposit rate, incentivizing banks to hold onto their ECB borrowing for now.
Key points
Arbitrage drives rapid TLTRO borrowing growth. The TLTRO borrowing rate is normally aligned with the ECB’s average deposit rate over the duration of the current TLTRO program. However, in March 2020, the ECB cut the TLTRO rate to -100 basis points, below its deposit rate of -50 basis points, as a pandemic support measure. This enabled European lenders to make profits by redepositing TLTRO loans with the ECB. TLTRO borrowing rose from around €600 billion at end-2019 to a record €2.2 trillion in June 2021, and remains at around the same level as of May 2022.
Rate rise extends arbitrage opportunity. On 23 June, the TLTRO rate will revert to the average ECB deposit rate. However, as a result of the ECB’s planned rate rises, the average deposit rate over the current TLTRO program will be lower than the new deposit rate. This will preserve a gap between the TLTRO borrowing rate and the deposit rate, keeping arbitrage opportunities open.
TLTRO usage influences covered bond issuance. Banks issue covered bonds to raise funding in public markets, and in the form of “retained issuance” to use as collateral for TLTROs. Public issuance has grown strongly in 2022, exceeding full-year levels for both 2021 and 2020 in May. This is partly because some banks considered prepaying their TLTRO loans from June in anticipation that the gap between the TLTRO rate and the ECB deposit rate would disappear. Now that this gap looks set to remain, public issuance could be more muted in the second half of 2022 and will likely increase again in 2023.
Liquidity coverage ratios (LCR) will deflate. We do not expect TLTRO repayments next year to trigger liquidity shortages. However, collateral for €1.6 trillion of TLTRO loans consists of instruments that do not qualify as High Quality Liquid Assets (HQLAs). These will be released as TLTRO loans are repaid, deflating some of the very high LCRs reported currently