Category Archives: Central Banks

Exchange on Promissory Notes with an AAA-Rated Correspondent

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This weekend, I received an email from an economist from a Triple AAA-rated Euro zone country in response to the briefing paper that I provided to the Oireachtas Finance committee. This person wished to keep their correspondence confidential so I’m not going to repeat their email. However, I think it might be useful to outline the nature of the exchange I had with them and to provide my response in public. While I don’t think this issue comes down to technical considerations, the exchange does shed some light on some of the technical matters likely being discussed behind the scenes.

My correspondent put forward a number of arguments.

  1. That Article 18.1 of the statute governing the ECB and Eurosystem says that lending from national central banks must be based on “adequate collateral” and that this applies to all lending, including ELA. They argued that the Eurosystem’s principles of collateral and haircuts should be considered “sacred”.
  2. That this means that the yield to maturity on promissory notes must be the same as the yield on marketable Irish government bonds, so any restructuring of the notes to reduce payments now must result in even higher payments later and this cannot help reduce Ireland’s debt burden.
  3. That publicly appealing to change the structure of the promissory notes amounted to the Irish government lobbying the ECB Governing Council to change its collateral policy, which undermined the Council’s independence, an issue which its members feel very strongly about.

In summary, my correspondent argued that a restructuring of the note that reduced Ireland’s debt burden was impossible and the Irish government arguing for such a restructuring would simply generate bad will among our European partners. The correspondent concluded by noting that they had nothing against the idea of some kind of deal aimed at reducing Ireland’s debt burden and made a brief reference to senior bank debt.

Here’s my response:

Dear X

I understand your arguments but I think this issue needs to be discussed in light of other recent events in the Eurosystem in recent months.

You may consider the practices of collateral valuation and haircuts to be sacred but you know that there has been a considerable shift in collateral policies over the past few years.  It’s a complicated crisis and lots of things previously considered unthinkable have happened.

You’re right that the Treaty mentions “adequate collateral” but it does not specify the meaning of “adequate”.  As I explained in my paper, it is my opinion that the letters of comfort and facility deeds provided to the Central Bank make the promissory notes different assets (more safe) than normal sovereign bonds which do not come with such assurances, so I don’t necessarily agree that they need to be valued in line with current Irish private bond rates.

You probably disagree with that argument but ultimately this is a judgment call for the Governing Council to make.  And now, with the GC having authorised €1 trillion in long-term loans, much of it against previously ineligible collateral, raising the question of a reworking of the collateral on a mere €28 billion is hardly unreasonable.

Even if you are right that the notes need to be valued using the current private bond rate, there is still some gain from a payment structure that backloads the repayments.  This would reduce the cash flow burden at a very sensitive time with Ireland attempting to return to the market to finance deficits and repay debts.  In addition, delaying payments on the note to a time when underlying fiscal retrenchment is over will allow for a smoother path of fiscal adjustment. (To understand the extent of adjustment so far in Ireland, I recommend page 20 of this PDF file of a Commission report on Ireland http://ec.europa.eu/economy_finance/publications/occasional_paper/2012/pdf/ocp93_en.pdf)

I’d note that in recommending delaying payment on the notes, I am not recommending that ELA repayments cease. The IBRC is selling assets and taking in reasonably large quantities of loan payments. It has sufficient assets to repay much of the ELA over the next few years even if there were no promissory note payments over that period.

In relation to independence, I know how the Governing Council works and have always made clear to people in Ireland that any changes to the notes would need to be discussed among Eurosystem staff and then brought to the Council to be considered. This is not a matter of politicians lobbying for the notes to be changed and I would note that the Irish government have been extraordinarily low key in their approach to this issue, hardly ever mentioning the Governing Council. The discussions which are taking place are at a bureaucratic non-political level, though I don’t believe they are making any progress towards getting the notes changed.

Anyway, thank you for taking the time to engage on this issue. I will do my best to be clearer about the issues relating to collateral quality and ECB independence in future. It’s also good to hear you are not against lightening the debt burden for Ireland, though I would note that there is very little IBRC senior debt left (less than €1 billion) and it’s not really possible to consider restructuring the debt of the other banks which have now been recapitalised. So I think a reworking of the notes would be beneficial.

Regards and thanks,

Karl

ECB Governing Council Discussions

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There have been a number of news stories in the past day or so (e.g. this one) which have noted that despite earlier stories flagging that Patrick Honohan was going to raise the issue of promissory notes at the ECB Governing Council meeting on Thursday, Mario Draghi said that it was not discussed at the meeting.

I think it’s probably worth pointing out that (at least as I understand it) the Governing Council members meet for dinner the night before the Thursday meeting and key issues often get discussed there so that when the actual meeting happens, the ECB President can say with a straight face in response to questions that certain issues were not even discussed at the meeting. It’s an old trick.

A better signal that, indeed, there is unlikely to be a re-working of the notes any time soon (or perhaps ever) was this story from the Irish Times written by Arthur Beesley, which is pretty clearly based on a briefing from an ECB insider (probably a high-ranking one).  Some of it is pretty painful, e.g.

Given that there is money available in the bailout plan to pay the €3.1 billion due on March 31st, the case is being made that any delay would seriously erode the Government’s standing with markets at a time when Ireland’s return to markets is still not assured.

The idea that sovereign bond investors are actually keen to see the government burn €3.1 billion a year on promissory note payments is fairly ludicrous.

This is also quite pointed:

Within the ECB, the view remains that alternative avenues are open to the Government to improve its finances, among them reductions in public sector pay and welfare entitlements.

The argument is made that average public pay and welfare levels in Ireland are higher than the average in some of the other euro zone countries that are supporting Ireland’s bailout, among them Spain, Slovenia and Slovakia.

I think there’s an element of apples and oranges here. Yes, more fiscal adjustment is required, and public sector pay and welfare rates are part of the mix. But the ultimate objective is to allow Ireland to finance itself independent of the EU and IMF and without some reduction of the burden of the existing debt, much of it bank-related, that probably isn’t going to happen.

Anyway, the key point is that if a deal doesn’t happen, it will be because the ECB Governing Council didn’t want a deal, not because Patrick Honohan failed to raise the issue.

The ECB and Loss-Sharing

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The ECB has released its annual accounts for end of year, 2011.  Expect to read lots of excitable commentary that focuses on the small size of the ECB’s “Capital and Reserves” of €6.5 billion relative to over €1 trillion that has been loaned out in long-term refinancing operations and the €284 billion in sovereign bonds purchased under the Securities Market Programme .

This kind of commentary misses a number of important points.

First, the ECB also has revaluation accounts and provisions, both of which can cover losses, worth €30 billion.

Second, and most important, the ECB does not actually do any direct lending to banks. As I discuss on page 7 to 9 of this paper, monetary policy operations in the Euro area are done on a decentralised basis and the ECB Governing Council interprets Article 32.4 of the ECB statute as implying the losses on these operations should be shared among Eurosystem central banks according to their capital share.

So what matters when thinking about whether there is loss-bearing capacity in relation to the LTROs is the size of the Eurosystem’s capital resources. A Eurosystem financial statement is released every week. It shows capital and reserves of €83 billion and revaluation reserves of €394 billion.  LTRO losses would need to be enormous to wipe €477 billion off the Eurosystem balance sheet.

Finally, while internet banter about poor quality Eurosystem collateral is a popular sport, the Eurosystem applies haircuts when lending, meaning the value of the underlying collateral is larger than the value of the loan. And the haircuts applied to the newly-eligible “credit claims” (i.e. bank loans) are huge.

All told, the prospect of recapitalising the Eurosystem should be very low down anyone’s list of worries about the European economy.