It was almost three years ago to the day when Zero Hedge first explained the biggest problem facing Europe when it comes to unconventional monetary policy: the lack, not scarcity, but outright shortage of collateral.
Initially, our focus was on private-sector collateral, and if one had to summarize the key difference between the US and Europe in one chart, it would be this one, showing that while in the US the split between secured and unsecured funding was roughly even, in Europe, some 90% of corporate funding was on bank loan books, with only 10% in the form of (unsecured) corporate bonds (which also explains why in Europe NPLs, aka bad bank debt is by far the biggest problem facing the financial industry).
Subsequently, we also showed that the collateral shortage is not only in the private bond market, but in the public one as well, because there simply wouldn’t be enough net supply in Europe to cover the ECB’s ambitious demands.
Three years later, and following the first week of direct ECB monetization in the bond market, we have proof not only that our warnings were accurate, but that the worst case outcome for the ECB – a failure to achieve its stated goals is now only a matter of time. The reason? After just a few days of intervention, the ECB’s grand monetization experiment has already managed to get derailed.
And then there is the just as critical issue of collateral scarcity.
But before we get into this point, we urge readers to refamiliarize themselves with the critical topic of shadow banking collateral volecity by rereading “What Shadow Banking Can Tell Us About The Fed’s “Exit-Path” Dead End“, since this is i) all that matters in a world in which every asset move is based on leverage of derivatives and in which the underlying collateral is so scarce, what matters is how efficiently its (re-)rehypothecated asset manifestation is re-used and ii) since virtually nobody actually understands this critical concept.
To be sure, our 2013 article was looking at the Fed’s “exit” pathway, one which will soon be all the more critical if indeed Yellen is hoping to not only hike rates soon but to actively unwind the trillions in excess reserves. This is what Peter Stella wrote a year and a half ago on this topic:
Many major central banks are thinking strategically about exit pathways – how best to return to normal central banking. The main point of this column is to point to a key issue – the role of collateral – that has been under appreciated by many economists who are not in daily contact with financial markets.
When economies strengthen and central banks begin to drain reserves from the system, they will inevitably alter the composition of private sector asset portfolios.
- If good collateral is swapped for reserves, banks and nonbanks can use the collateral to fund create credition via what are known as collateral chains.
- If only term deposits are swapped for reserves, or if interest rates are raised only through IOR, the opportunity to lengthen collateral chains will be missed.
In today’s financial world, these chains are critical sources of money and credit creation – the days of textbook money-multipliers are long gone.
When it comes to reducing excess reserves, the ‘how’ matters as much as the ‘when’ and ‘how much’. Understanding this point requires mastery of the brave new world of shadow banks and re-hypothecation – a world that either did not exist or was truly in the shadows when most of us were taught about money and credit creation.
Full article: The Full Explanation Of How The ECB Broke Europe’s Bond Market (Zero Hedge)