The ECB’s policy response to the Covid crisis has been game changing, but has also added to the list of risks that undermine financial stability. The disruption to wholesale bank funding is a case in point

In the midst of an unprecedented economic contraction, it is easy to overlook how game changing the ECB’s policy response to Covid has been. The PEPP has bought the ECB’s toolkit in line with its peers and achieved immediate success in defusing the risks of financial fragmentation and easing financing conditions.

Lending to the private non-financial corporate sector has surged and household borrowing has been gradually picking up. In the periphery, where financial conditions have eased further than the core, the rebound in lending has been particularly strong.

Source: Bloomberg, Macrobond  and Variant Perception

However, these apparent successes come at the cost of heightened risks to financial stability. The impact of a flat term-structure on bank profitability (alongside the cost of negative deposit rates) and the sharp rise in the stock of negative yielding debt are issues that we have highlighted before. The provision of extremely accommodative TLTROs compounds these risks further. Under the current iteration (TLTRO-III) banks can borrow from the ECB at as low as -1% contingent on lending to the private non-financial sector.

Source: Bloomberg, Macrobond  and Variant Perception

Ultra-cheap funding, alongside a banking system awash with liquidity due to the various asset-purchase programmes, has disrupted the traditional market for wholesale funding. Euribor has not only collapsed, but now trades inside overnight unsecured rates (ESTR and EONIA).

Source: Bloomberg, Macrobond  and Variant Perception

The ECB’s latest Bank Lending Survey further bears this out. While the majority of TLTRO funds have been used for lending to the economy, a significant proportion of respondents indicated that funds have also been partly used to replace interbank borrowing.

Source: Bloomberg, Macrobond  and Variant Perception

The longer that the ECB provides such abundant liquidity, the more difficult it will be to withdraw funding and normalise the interbank market. If the market microstructure and bank business models change as a result of the ECB’s liquidity provisioning measures, it may eventually prove difficult to transition back to wholesale funding. Furthermore, this would bring the possibility of recurrent stresses similar to those seen in the UST repo market and with the cross-currency basis.