As a response to the 2008 credit crisis, the ECB pursued a policy of monetary easing to stimulate economic growth and bring inflation closer to its target of 2%. This has resulted, among other things, in a very long period of negative interest rates. In the meantime, the tide has completely turned and we are in a period of hyperinflation. The ECB has taken four major steps to raise interest rates in 2022 and the end is not yet in sight.
In addition, the ECB has adjusted the TLTRO funding, which has made this funding considerably more expensive from 23 November 2022 onwards. Given the enormous size of the TLTRO operation and its large share in the funding of the banks, this adjustment has consequences for lending activities of banks.
In July 2022 banks have already increased the internal funding rates they use as a basis for their lending activities. As a result of the ECB's first interest rate hike on that date, the advantage of the negative Euribor has disappeared for banks. Due to the adjustment of the TLTRO funding rates, the internal funding rates, and therefore the surcharges that companies pay on bank financing, will further increase from the end of November 2022 onwards.
On 15 December 2022, the ECB raised its interest rates by 0.5%. The last increase dated from 27 October, at which meeting the ECB also took the decision to make the interest to be paid by banks on the outstanding TLTRO funding more expensive and at the same time to give the banks additional opportunities to prepay the outstanding TLTRO funding.
As we have described in our previous contributions, the ECB made a number of adjustments to the TLTRO program in the period September 2019 to December 2020 with a view “to granting exceptionally favourable financing conditions”.
Now that macroeconomic conditions have been completely turned upside down in 2022 and the ECB is struggling to get inflation back under control, the ECB is taking interim measures to make TLTRO funding less attractive. The ECB aims to achieve two effects with this measure. On the one hand, to accelerate the pace at which banks translate higher ECB interest rates into the conditions of their lending activities, with the aim of slowing down the demand for credit. On the other hand, to shorten its balance sheet and reduce the money supply in circulation.
The outstanding TLTRO loans are TLTRO III loans, which were issued in ten series between September 2019 and December 2021, with a maturity of 3 years.
The ECB has decided to adjust the outstanding TLTRO III loans in two respects:
"From 23 November 2022, interest rates on all remaining TLTRO III operations to be indexed to average applicable key ECB interest rates from that date onwards.
Modification accompanied by three additional voluntary early repayment dates..."
The additional penalty-free repayment options concern 23 November 2022, 25 January 2023 and 22 February 2023. These dates are in addition to the possibility to repay every 3-month period (from 12 months after the start of the term) without penalty.
The 'indexation' of the interest rate requires some explanation.
The interest that banks have to pay on the TLTRO loans is linked to the ECB interest rates. The entire scheme is complex and has many variants, depending on the extent to which a bank has maintained its credit provision at the various measurement moments. Banks that have met the strictest minimum tests at the measurement moments, have been rewarded with an additional interest rate discount:
SIRP: Between June 24, 2020 and June 23, 2021, there was a ‘special interest rate period’, in which these banks received a discount of 0.5% on the Deposit Facility rate (which at that time was 0.5% negative).
ASIRP: Between June 24, 2021 and June 23, 2022, there was an ‘additional special interest rate period’, in which these banks received a discount of 0.5% on the Main Refinancing Operations rate (which was 0.25% negative at the time).
The above two periods with extra discount have received a lot of publicity as a result of the high contribution to the results of the banks over those periods.
What has remained under the radar is a second sweetener, which is hidden in the scheme: for the periods preceding, and following the SIRP and ASIRP (the 'rest of life period'), the interest rate is based on the average Deposit Facility rate measured over the entire term (so again including the SIRP and ASIRP period on which a discount has already been obtained). The SIRP and ASIRP together cover the period from 24 June 2020 to 23 June 2022. Because the Deposit Facility rate was 0.5% negative throughout the period, this has a major effect on the interest rate for the 'rest of life period'. We illustrate this advantage on the basis of the following calculation examples, which each show how this works out for 3-year loans:
Table 1: Interest benefit of the original scheme
The benefit depends on the time of issue (maximum benefit when issued at the end of 2020) and the level of the average Deposit Facility rate after 23 June 2022 (the higher, the more benefit). For illustration, we have included in Table 1 an average Deposit Facility rate after 23 June 2022 of 2.0%, equal to the last increase of December 15th.
It is this second sweetener that the ECB will largely take away from the banks as of November 23, 2022. To do this, the ECB cuts the 'rest of life period' into two periods, the 'main interest rate period' and the 'last interest rate period':
The ‘main interest rate period’ runs until 22 November 2022. The interest rate is based on the average Deposit Facility rate during the 'main interest rate period' (i.e. including the double benefit of SIRP and ASIR). This period has now ended.
The 'last interest rate period' starts on 23 November 2022. The interest rate is based on the average Deposit Facility rate from 23 November 2022 until the moment of (early) repayment.
The 'main interest rate period' consists of: the pre-SIRP, the SIRP, ASIRP and the post-SIRP.
The pre-SIRP ends on June 23, 2020. For simplicity, we have only included loans in Tables 1 and 2 that started after 23 June 2020. For these loans, there is no pre-SIRP.
The post-SIRP starts on 24 June 2022 and runs until 22 November 2022, or 152 days. The average interest rate on the post-SIRP was 0.41%
In the table below we illustrate the lower benefit over the term of the modified scheme of the TLTRO:
Table 2: Interest benefit adjusted scheme
The above calculation example shows that a very large part of the interest benefit is taken away from the banks. In addition, the benefit is fixed as of November 22 and is no longer dependent on the future development of the Deposit Facility rate as before.
As a result, a jump is made in the applicable interest rate. For example, for a loan started on 31 December 2020, the interest rate until 22 November is on average 0.71% negative, from 23 November onwards the interest rate is linked to the Deposit Facility rate, currently 2.0%. Hence, a jump of 2.71%.
Reactions of the banks
To put it mildly, the banks are 'not amused'. Understandable because the rules of the game are changed during the match.
Under the original scheme (Table 1), we see an average benefit of around 15 million per loan of EUR 1 billion. Since the banks have borrowed more than € 2 thousand billion in TRLTR III loans, this gives a total benefit for the banks of approximately € 30 billion. Based on the adjustments (Table 2), this benefit is reduced to approximately € 4 billion.
The above absolute benefit can also be expressed as a funding rate relative to the Deposit Facility rate during the 'rest of life period'. Based on the original arrangement, the funding rate for an issue at the end of 2020 in this period is Deposit Facility rate minus 1.18%. For an issue at the end of 2021, this is the Deposit Facility rate minus 0.34%. Under the adjusted scheme, the funding below the Deposit Facility rate has been settled, and the funding rate for the banks will be equal to the Deposit Facility rate from 23 November 2022.
In the money market, the Deposit Facility rate is considered a floor in interest rates. This is the interest rate at which the banks can store money overnight at the ECB. The alternative for a bank is to store the money overnight at another bank. Given the credit risk involved, the interbank rates (€STR and Euribor) are normally above the Deposit Facility rate.
In the comparison with the interbank money market, two reservations must be made.
In the first place, the Euribor is an average. The interbank interest rate for an individual bank will be above or below the Euribor depending on the credit risk.
Secondly, Euribor is based on unsecured financing. To be eligible for TLTRO, a bank must hold sufficient collateral with the ECB.
If we compare the TLTRO funding with similar bonds issued by a bank, then the TLTRO is relatively expensive funding for most banks under the amended scheme (average Deposit Facility rate) from 23 November 2022.
The market and the ECB had therefore expected banks to make substantial repayments on the outstanding TLTRO loans after the announcement of the adjustments to the TLTRO scheme. However, the repayment in November was limited to less than € 300 billion, or 15% of the outstanding amount. The two most frequently cited reasons for the limited repayment in November are:
The positive contribution that the TLTRO makes to the Net Stable Funding Rate (NSFR*) at the next measurement moment at the end of December 2022. After January 2023, approximately 54% of the outstanding TLTRO loans no longer contribute to the NSFR.
The limited access that the less creditworthy banks have to liquidity, which makes them reluctant to repay TLTRO loans early.
Consequences for corporate financing
Within banks, the central treasury charges the applicable internal funding rate to client facing activities when they want to provide a loan to their clients. How the central treasury sets the internal funding rates is a black box, with very few people within the bank having insight.
It seems highly likely that the central treasury looks at TLTRO funding from a marginal perspective. In other words, when issuing new rates, they do not look at average interest over the entire term, but at the interest rate applicable from 23 November, namely the Deposit Facility rate. If the central Treasuries of the banks look at the TLTRO funding in this way, this will have an upward effect on the funding rates, which they pass on to the lending activities.
Looking even further ahead, we see that of the outstanding TLTRO loans (€ 1,610 billion after the repayment of November 2022), € 982 million, or 61%, will mature on 23 June 2023. The way in which banks will fill this gap in their funding, with or without the help of the ECB, will also be determining the development of funding costs in 2023.
*The NSFR means that banks need to (partially) offset long exposures (committed credit lines and loans) with long funding.