Long-term Refinancing Operations
LTROs and the European Debt Crisis
The financial industry is famous for its acronyms, from CPA to CDS, and new terms seem to spring up with each financial innovation or crisis. During the European sovereign debt crisis, the acronym LTRO was coined to represent "long-term refinancing operations", which were used by the European Central Bank (ECB) to lend money at very low interest rates to eurozone banks.
How LTRO Work to Support Growth
LTROs provide an injection of low interest rate funding to eurozone banks with sovereign debt as collateral on the loans. The loans are offered monthly and are typically repaid in three months, six months, or one year. In some cases, the ECB used longer-term LTROs, such as the three-year LTRO in December of 2011, which tend to see significantly higher demand.
The LTROs are designed to have a two-fold impact:
- Greater Bank Liquidity - Access to cheap capital encourages eurozone banks to increase lending activities that spur economic activity, as well as invest in higher yielding assets in order to generate a profit and improve a problematic balance sheet.
- Lower Sovereign Debt Yields - Eurozone countries can use their own sovereign debt as collateral, which increases demand for the bonds and lowers yields. For instance, Spain and Italy used this technique in 2012 to lower their debt yields.
LTRO operations themselves are conducted via a fairly standard auction mechanism. The ECB determines the amount of liquidity that is to be auctioned and requests expressions of interest from banks. Interest rates are determined in either a fixed rate tender or a variable rate tender, where banks bid against each other to access the available liquidity.
LTROs during the European Debt Crisis
LTROs became popular during the European financial crisis that began in 2008 and lasted for about three years. Before the crisis hit, the ECB's longest tender offered was just three months. These LTROs amounted to just 45 billion euros that represented about 20 percent of the ECB's overall liquidity provided. As the crisis evolved, these LTROs became much longer in duration and larger in size.
Some important milestones that occurred during the sovereign debt crisis included:
- March 2008 - The ECB offers its first supplementary LTRO with a six-month maturity is more than four times oversubscribed with bids from 177 banks.
- June 2009 - The ECB announces its first 12-month LTRO that closes with over 1,000 bidders in sharply higher demand than previous LTROs.
- December 2011 - The ECB announces its first LTRO with a three-year term with a 1% interest rate and usage of the banks' portfolios as collateral.
- February 2012 - The ECB holds a second 36-month auction, known as LTRO2, that provides 800 eurozone banks with 529.5 billion euros in low interest loans.
Since the programs, the bank has announced so-called Targeted Long-term Refinancing Operations —or LTLRO and LTLRO II—to further boost liquidity. These new operations are being conducted through at least March of 2017 on a quarterly basis in order to shore up liquidity and continue to support growth until inflation reaches the desired target levels.
Alternatives to LTROs for Liquidity
Shorter-term repo liquidity measures provided by the ECB are called main refinancing operations (MROs). These operations are conducted in the same manner as LTROs, but have a maturity of one week. These operations are similar to those conducted by the U.S. Federal Reserve to offer temporary loans to U.S. banks during hard times to shore up liquidity.
Eurozone countries can also access liquidity through Emergency Liquidity Assistance (ELA) programs. These "lender-of-last-resort" mechanisms are designed to be very temporary measures designed to help banks during times of crisis. Individual countries have the ability to run these operations with an ECB override option, although they are less common than other operations.
What It Means for Investors
LTROs can have a big impact on the market depending on their duration and size. Often times, the market will react positively when unexpectedly large measures are announced since the move tends to increase liquidity and bolster the financial system.
Despite the short-term gains, the long-term impact on these operations is debatable and uncertain, which means that the long-term impact for investors varies.