By Dhara Ranasinghe
LONDON (Reuters) – Already facing a likely growth slowdown, the euro zone risks a sudden tightening of financial conditions next month should banks across the bloc use the opportunity to repay billions of euros in cheap loans taken from the European Central Bank.
Such repayments could in turn boost the euro and the bloc’s borrowing costs, an unwelcome development for policymakers after data this week signalled economic growth probably failed to pick up in the second quarter of the year.
June brings the first early repayment date for almost 400 billion euros ($471 billion) of targeted long-term refinancing operations (TLTROs), designed by the European Central Bank to encourage lending to the real economy.
A first series of TLTROs was launched in 2014, and a second in 2016. They provided banks with interest-free funding and even the possibility of a rebate if they lent the cash on to businesses and households.
The loans had a four-year maturity, with a quarterly option to repay early from two years after the loan was taken out.
Early repayments for the first series of TLTROs fell due in 2016 and most of those loans were rolled over into the second series, analysts said.
According to Swedish bank Nordea, early TLTRO repayments in June could top 110 billion euros.
That estimate is based on a comparison with 2013, when unexpected early repayments of a previous series of cheap three-year loans totalling 137 billion euros offered by the ECB to help fight the euro zone debt crisis caught markets by surprise.
Graphic: The ECB’s balance sheet – https://reut.rs/2Lq5j8W
Other banks’ estimates put the expected figure for next month in the region of 100 billion euros.
The ECB declined to comment on repayment expectations.
Peter Kinsella, head of currency and rates strategy at CBA, sees two reasons why banks will repay a sizeable portion of the TLTRO loans.
First, they no longer require the same degree of central bank support. CBA estimates that the average Tier 1 equity ratio, a measure of a bank’s financial strength, is around 14 percent versus 8 percent before the 2008 financial crisis.
The recovery in euro zone banks was highlighted by first quarter earnings — 85 percent of banks in the MSCIEMU index met or beat analyst expectations, according to I/B/E/S data.
Second, CBA says that because various regulatory levies faced by banks are proportional to the size of their balance sheets, early repayment of ECB loans will help reduce that balance sheet and in turn potential charges.
“If euro zone banks voluntarily repay a significant proportion … we anticipate front-end euro zone yields may lift aggressively, because the early repayment implies a tightening of monetary conditions,” said Kinsella.
European Commission data shows euro area monetary conditions have already tightened in recent months, partly because of the euro’s strength at the start of 2018 and throughout last year.
A further tightening could take investors by surprise.
German two-year bond yields remain deeply negative, at minus 0.61 percent <DE2YT=RR>.
Some strategists said that while early TLTRO repayments was not their base-case for June, this could happen in September — the banks’ next opportunity to pay back the ECB early.
Traders say there were few immediate concerns about early loan repayments being made — especially since interest rates at minus 0.4 percent for two more years under the TLTRO remain attractive, and potentially shelter banks from a rate rise over that period.
Also, many banks are believed to be still assessing what they might do.
One strategist said it made financial sense for banks to start repaying these loans only when the maturity of the loans drops to a year because after that they become less attractive to hold.
Also, even if banks decide to repay their loans early, the ECB will still continue its 30 billion euros a month of bond purchases until September at least. That means its balance sheet will still be expanding and pumping cash into the economy.
For Nordea chief analyst Jan von Gerich, though, these ECB purchases may not be big enough to offset the impact of early TLTRO repayments.
“Given that the ECB is on the final stretch of its net bond purchases, the remaining bond purchases may never be able to compensate for the flow of early TLTRO repayments,” he said.
“The ECB’s balance sheet could start to contract well before the first rate hike and even before the end of the net bond purchases.”
This would stand in contrast to the U.S. Federal Reserve, which did not let its balance sheet start contracting until more than 1-1/2 years after its first post-crisis rate hike, he said.
For others, the incentive to pay back loans early was linked to facing up to the reality of the changing monetary policy backdrop globally.
“This is not an issue for right now, but it could be later in the year as central banks globally tighten their policies — essentially the unwinding of global QE,” said Patrick O’Donnell, investment manager at Aberdeen Asset Management.
(Reporting by Dhara Ranasinghe; Additional reporting by Sujata Rao and Kit Rees in LONDON and Balazs Koranyi in FRANKFURT; Editing by Catherine Evans)