Draghi Had to Expect Calls for New Long-Term Refinancing Operation; The crisis shows that no central bank can easily escape from its unconventional monetary policies

Updated October 14, 2013, 7:45 p.m. ET

Draghi Had to Expect Calls for New Long-Term Refinancing Operation

The crisis shows that no central bank can easily escape from its unconventional monetary policies.

SIMON NIXON

Until recently, the European Central Bank could be forgiven for feeling a little smug. All of the major central banks have massively expanded their balance sheets since the start of the crisis. But while the U.S. Federal Reserve continues to accumulate assets to the tune of $85 billion a month—too nervous about the market’s reaction even to scale down its money-printing—the ECB balance sheet has been steadily shrinking.This owes as much to luck as to judgment. The ECB found it politically very difficult to engage in Fed-style large-scale bond purchases. So at the height of the euro crisis in December 2011, it injected liquidity into the system by providing banks with cheap three-year loans instead.

At the time, these so-called Long-Term Refinancing Operations were conceived as a classic lender of last resort facility that helped prevent a meltdown in the euro-zone banking system, providing banks with enough medium-term funding certainty to avoid asset fire sales, ease solvency fears and halt deposit flight. The LTROs brought an additional benefit: some banks used the loans to buy government bonds, helping to drive down yields.

Since then, however, the crisis has eased and healthy banks have been repaying those loans. Much to the ECB’s satisfaction, the amount outstanding has already fallen to €660 billion ($894 billion) from €1.1 trillion at the peak. While other central banks are still grappling for an exit strategy, the ECB has appeared to be already halfway out the door.

But the lesson of the crisis is that no central bank can escape from its unconventional monetary policies easily. Once markets have tasted the forbidden fruit, they have a habit of coming back for more. No surprise, then, that the ECB now finds itself under growing pressure to expand its balance sheet again with a new LTRO.

This pressure is coming partly from macroeconomists who worry that if the ECB’s balance sheet shrinks much further, liquidity will become too tight and market interest rates will start to rise. For them, the appeal of an LTRO is that it is a form of backdoor quantitative easing: the banks can use the cash to buy bonds and drive interest rates back down.

But pressure is also coming from banks and policy makers in Europe’s crisis countries, who warn that the euro-zone banking system is still not stable enough to withstand the withdrawal of these ECB facilities as scheduled at the end of next year. After all, Greek banks continue to rely on the ECB to fund 18% of their assets, Portuguese banks 10% and Italian banks 6%, according to Citibank. They worry that any uncertainty over the future availability of long-term central-bank funding facilities after the LTROs expire could create new risks to financial stability.

Indeed, the question of what liquidity the ECB is willing to provide to weak banks and on what terms has acquired greater urgency as the ECB gears up for a comprehensive review and stress test of the balance sheets of the euro zone’s largest banks before it takes over responsibility for financial supervision next year. Higher funding costs could lead to bigger capital shortfalls, putting new pressure on countries with weak finances.

But as always when monetary policy becomes entwined with financial-stability considerations, the provision of a new LTRO isn’t the simple panacea it may seem. Devising a new LTRO that meets the different needs of monetary policy and financial stability isn’t going to be easy. The risk is that it creates new perverse incentives, market distortions and unintended consequences.

For example, if the main objective from a monetary-policy perspective is to inject new liquidity into the system, then the ECB will need to find a way to maximize takeup. Indeed, the ECB’s credibility would be damaged if participation were low. But how does the ECB persuade banks to sign up when many have been repaying existing loans?

Morgan Stanley suggests the solution is to offer the new loans at a fixed rather than floating rate, perhaps even after a rate cut, making the money so cheap that banks can’t refuse. This would have the advantage of reinforcing the ECB’s efforts to provide guidance to the markets on the likely future path of interest rates.

But from a financial-stability perspective, the goal must surely be to minimize reliance on central-bank facilities. Providing a generous new subsidy to weak banks risks sending exactly the wrong signal, reducing incentives to write down bad loans to realistic values, relieving pressure to scrap broken business models and perpetuating an unlevel playing field.

Similarly from a monetary-policy perspective, the ECB might be happy to allow banks to continue to use the loans to fund purchases of government bonds. After all, keeping government bond yields low is an important part of the rationale for a new LTRO.

But from a financial-stability perspective, it might make sense to exclude the use of government bonds as collateral—an idea that some policy makers are considering. At least that would make it harder for weak banks to try to boost their profits through carry trades, diverting money that could be used for new lending into the real economy. Crucially, by reducing incentives to hold government bonds, it would also weaken the link between banks and sovereigns.

The truth is that this isn’t a debate the ECB expected to be having so soon. But the issue has been pushed up the agenda by a combination of uncertainty over the Fed’s tapering plans, anxiety over the ECB’s banking-system review and ECB President Mario Draghi’s attempts to talk down interest rates by promising to do whatever is necessary.

The risk is that expectations build to the point where the ECB feels obliged “to do something” even if the rationale remains fuzzy. That won’t bother the market, which will greet any new liquidity with its customary enthusiasm. But it certainly wouldn’t be anything to be smug about.