The ‘long term refinancing operation’ – LTRO – is supposed to stop a massive European credit crunch. But what is it and how does it work? Indeed, will it work at all? Tim Bennett explains.
The Long Term Refinancing Operations (LTRO) of the European Central Bank (ECB) are designed to provide stability to Europe’s banking sector and keep sovereign bond yields down to sustainable levels (below 6% in the case of Spain). The mechanism is the ECB supplying funds to the banks at 1% for up to three years.
The banks in turn have to post collateral to secure these funds. The lower the quality of this collateral, the bigger the ‘haircut’ – ie, the lower the amount that can be borrowed. These funds can find their way into sovereign bonds, which carry a higher yield than 1%, allowing the bank to make a profit on the exercise. This buying should also push up prices and force down yields.
Another possibility is the banks hoard the money by putting it back on deposit at the ECB (at a lower rate). It can then be use to repay private funding at a later date. The least likely option is the money is lent out to firms and individuals, most of whom are currently debt-averse.
• Entry from MoneyWeek's Financial glossary.