ECB Meeting: Looking Intensively at Credit Tightening Risk

• The ECB kept the leading interest rate unchanged at 1% as expected. We continue to expect the ECB to leave the refinancing rate unchanged until 2014. The chance of more rate cuts has diminished further.
• Mario Draghi expressed concern about the signs of a credit tightening. In the case of a broad-based credit contraction in the euro area, we expect policy reaction from the ECB, EBA and/or governments.
• Draghi declined to comment on how the ECB's holding of Greek sovereign bonds would be treated but de facto ruled out taking a loss. We expect the ECB to sell its Greek bonds at purchase price.
• The market reaction was muted, as the ECB delivered as expected. Investors reacted positively to the news that Lucas Papademos had informed Draghi just before the press conference that a deal had been reached in Greece.

ECB on hold

The ECB kept the refinancing rate unchanged at 1% as expected by most analysts. At the press conference, Draghi highlighted that "survey indicators confirm some tentative signs of a stabilisation in economic activity". This signals that the ECB's concerns regarding the growth outlook have diminished somewhat since the last meeting.

Draghi stated that the inflation outlook remains broadly balanced. Inflation is expected to stay above target in the coming months before falling below 2%. So, the inflation outlook is in line with the ECB target.

We continue to expect the ECB to keep its leading interest rate unchanged at 1% until 2014. Draghi stated that a change in the leading rate had not been discussed. In our view, the likelihood of a rate cut has diminished further and the possibility of a rate increase earlier than 2014 has increased slightly.

Risk of credit tightening

Draghi showed concerns about the risk of a credit tightening. This is due in part to the need to increase the core tier one capital ratio to 9%. Draghi said that recently there have been declining loan flows to the real economy. This is particularly pronounced in loans to the non-financial sector. He also mentioned the tightened credit standards from the ECB bank lending survey. The survey shows that credit tightening is taking place for companies, consumer credit and credit for house purchases in some countries. ECB is looking intensively at current developments, although Draghi did say that it is too early to draw conclusions as the impact of 3Y LTRO may not be fully reflected in the December numbers released last week.

In the case of a broad-based credit contraction in the euro area, we would expect a policy reaction that could take the form of one or more of the following measures: (1) the ECB could announce further non-standard measures, (2) the EBA could adjust capital requirements in a way that gives more incentives to lend to the real economy, (3) postpone the 30 June 2012 deadline or (4) banks could be forced to undertake additional recapitalisation, possibly with a forced recapitalisation with government money.

Greek PSI

Draghi confirmed that an agreement had been reached in Greece. He declined to comment on how the ECB's holding of Greek sovereign bonds will be treated. However, he said that taking a direct loss would be equivalent to monetary financing of sovereign nations, de facto ruling out selling the bonds to the European Financial Stability Facility (EFSF) at a price lower than the purchase price. A Eurogroup meeting will take place tonight, where both the second rescue package for Greece and the PSI agreement are expected to be presented in detail. We expect the ECB to sell its bonds at purchase price.

3-year LTRO

As a follow up to the LTRO announcement from December, details of a further broadening of the eligibility criteria for additional credit claims were released following the ECB-meeting (see statement).

The ECB has approved proposals relevant for acceptance of additional credit claims as collateral in the credit operations put forward by seven central banks, namely Central Bank of Ireland, Banco de España, Banque de France, Banca d'Italia, Central Bank of Cyprus, Oesterreichische Nationalbank and Banco de Portugal (see national central banks for further details). The other national central banks are working on preparing similar proposals for temporary approval of credit claims as collateral. The broadening of the collateral base can potentially increase the usage of the second LTRO substantially compared with the first one.

Draghi refrained from giving any estimate on the expected usage of the upcoming threeyear LTRO. It was clear that Draghi was comfortable about the substantial market relief following the introduction of the three-year LTRO. We expect banks to take around EUR300-600bn at the 3Y LTRO. According to Reuters, forecasts now range from EUR75bn to EUR800bn and there is still talk of EUR1tr. We expect banks to take around EUR300-600bn

Market reaction

The market implication was muted following the "wait and see meeting". Markets reacted positively to the news of a deal in Greece.