Eurozone banks get help from ECB collateral measure

A small step for the ECB, a big step for eurozone banks could be one way of looking at a recent announcement by the European Central Bank that it is widening the array of financial instruments that it is accepting as collateral for its monetary operations.

Currently, the ECB accepts as collateral only three types of non-marketable (not traded on an exchange) debt: fixed-term deposits from eligible banks, credit claims (bank loans) and retail mortgage-backed debt instruments (RMBDs).

From November 2, the national banks of the eurozone member states will be able to add another type of collateral to the instruments they accept from banks in exchange for loans: non-marketable debt instruments backed by eligible credit claims, also known as DECCs.

I know this is a mouthful and as dry as dust, but do try to read on; this could turn out to be a very big deal for banks in the eurozone.

A big difference between banks in the eurozone and banks in the US has been that banks in the US were able to “export” their losses via bonds to the capital markets, whereas European banks are still stuck with the loans on their balance sheet.

The following chart from RBS is a good illustration of how far apart the two banking systems are:

Eurozone banks are still stuck with legacy debt. Source: RBS

Eurozone banks are still stuck with legacy debt. Source: RBS

Essentially, it sounds like this could change soon. DECCs are instruments made of packaged bank loans, which can include any type of loan as long as it meets certain conditions.

The loans must have been extended to debtors in the eurozone by banks based in one of the eurozone member states. The issuers of the DECCs must be special purpose vehicles (SPVs) based in the eurozone, and which buy the credit claims that make up the DECCs from the eurozone banks.

Potentially, if this goes well eurozone banks would be able to offload much more debt and park it with the ECB, freeing their balance sheet so that they could lend more to corporations in the single currency area.

Taken together with the central bank’s other measures, such as the targeted long-term refinancing operations (TLTROs) and the asset purchases under its quantitative easing programme, this could truly mark the end of the eurozone debt crisis, because it means the ECB will now in effect backstop most of the debt in the euro area.

In time, this could mean that the ECB will eventually become the same with the Federal Reserve and the Bank of England, which are able to help their countries’ banks direct if they fall into trouble.

It’s not the case yet; only the national banks of eurozone members will be able to accept DECCs as eligible collateral for now, not the Frankfurt-based ECB. But this is an insignificant detail; the Eurosystem, at the end of the day, is made up of the eurozone members’ national banks.

For those wanting more details about DECCs, they are instruments that are, in the ECB’s words:

  • backed, directly or indirectly, by credit claims that satisfy all Eurosystem eligibility criteria for credit claims;
  • that offer dual recourse to: (i) a credit institution that is the originator of the underlying credit claims; and (ii) the dynamic cover pool of underlying credit claims referred to in point (a);
  • for which there is no tranching of risk;

Some of the eurozone members will probably not like the fact that the ECB is slowly becoming the area’s bad bank of choice. However, there is no other way to ensure the single currency area leaves the debt crisis behind.