 The European Central Bank and its president, Christine Lagarde, are implementing policies aimed at reducing liquidity in the euro system to help lower inflation. Source: Thomas Lohnes/Getty Images |
Eurozone banks are set for a squeeze on profits and liquidity as they prepare to repay almost €500 billion of cheap funding borrowed from the European Central Bank during the height of the COVID-19 pandemic.
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At €476.8 billion, the paydown on June 24 is the largest installment due on the approximately €2.2 trillion of funding taken from the ECB's third targeted longer-term refinancing operation (TLTRO III). The ultra-cheap funding, which was distributed from 2019 to 2021, was designed to boost lending to the real economy and generate growth.
The scale of the June repayment is expected to spark greater competition among banks for deposits to replace some of the lost liquidity, thus pushing up interest expenses. Costs are also set to rise as lenders turn to debt markets for alternative sources of funding.
"This is going to have an impact on profitability because one very cheap liquidity source is going to end," said Pablo Manzano, vice president for financial institutions at credit rating agency DBRS Morningstar. "Banks will have to go back to normality and pay more for deposits and maybe issue covered bonds [to support liquidity levels]."
Less liquidity
Liquidity among the eurozone's largest banks has declined in three of the last four quarters as TLTRO III funds have been repaid, with the other quarter remaining flat, S&P Global Market Intelligence data shows.
The median liquidity coverage ratio (LCR) — a measure of a bank's ability to meet its short-term financial obligations — at a selection of the eurozone's largest banks fell more than 1,300 basis points to 177.6% in the first quarter of 2023 from the same period a year earlier, the data shows. Almost €740 billion in TLTRO III funding was repaid during the period, according to Market Intelligence calculations based on ECB data.
LCRs among most European banks remain well above the 100% minimum required by European regulators. Still, since the failures of several banks in the US and the Swiss-government-orchestrated takeover of Credit Suisse by UBS in March, many commentators have highlighted the vulnerability of bank liquidity in the age of digital bank runs, where billions in deposits can be withdrawn in a matter of hours.
"I understand market concerns," said Gonzalo López, bank equity analyst at capital markets research firm Redburn. "The LCR ratio has been something we didn't care about in the last three or four years. Now it seems that it's more relevant than the capital ratio because liquidity could be a major issue for a bank, as we saw recently in the US."
Q2 hit
The June repayment of €476.8 billion is expected to have a notable impact on LCR ratios in the second quarter for those banks due to repay large sums of TLTRO funding.
"That's something to monitor — if all banks will be able to manage the transition effectively the same way," said Nicolas Hardy, deputy head of financial institutions ratings at Scope Ratings. "[Some] banks have warned that their LCR will go down materially."
The repayment of TLTRO III and other central bank funds "might cause a significant reduction of the LCR at EU level" unless it is replaced by alternative funding sources, a June 15 European Banking Authority report warned.
"While the weighted average LCR for the entire EBA sample would stay above the minimum requirements, specific institutions [including other systemically important institutions] may need to initiate actions to maintain operating with prudent LCR levels," the report said.
The maturity of all remaining central bank funding could cause a similar fall in eurozone banks' weighted average net stable funding ratio (NSFR), the report added. The NSFR is the proportion of a bank's long-term assets covered by stable sources of funding. The median NSFR at eurozone banks stood at 124.7% in the first quarter of 2023, having fallen consistently from 131.6% in the second quarter of 2021, Market Intelligence data on a selection of eurozone lenders shows.
Early repayments
The reduction in eurozone bank liquidity in the first quarter followed an adjustment to the terms of TLTRO III in October 2022. Many banks took the opportunity to repay some or all of their TLTRO funds early following the change by the ECB, which was aimed at accelerating its tightening of monetary policy as it fights inflation.
Early repayments of TLTRO funds have slowed in recent months, suggesting that banks have become more keen to hold on to cheap liquidity. Just over €200 billion has been repaid early in the four repayment windows since the beginning of 2023. In the June repayment window, only €29.5 billion of the almost €600 billion in outstanding funds due after June was repaid early.
"Given the conditions, banks are going to stick to paying back TLTRO funds as they mature," said Manzano. "I don't think we are going to see many more earlier repayments."
Focus on Italy
Banks in Italy have been among the largest recipients and retainers of TLTRO III funding. Italian lenders held €319 billion in TLTRO III funds on their balance sheets at the end of March, about 29% of the total in the euro system, an April report from DBRS Morningstar said. About 45% of Italian banks' outstanding TLTRO funds will expire in June, it added.
Reports in recent months have flagged a potential shortfall in liquidity for some Italian banks as they repay TLTRO III funds. These lenders are likely to see a significant increase in funding costs as they tap alternative sources of money to remain above the 100% LCR limit.
"Banks that had low LCRs in the first quarter might need to raise funding just to match the regulatory minimum," Johann Scholtz, bank equity analyst, at US financial services firm Morningstar. "Those banks could potentially be in a spot of bother."