Eurozone Banks

Is There Life After TLTRO?

21 November 2018
4 Minute Read

Eurozone banks are watching the clock tick down on the European Central Bank’s (ECB’s) special support operations, which will start to lose effect from June 2019. Italian banks will be impacted the most. Investors should watch out for volatility—and pick their bank investments carefully.

Since 2014, the ECB has helped struggling banks across the eurozone with a novel support mechanism—but this has a limited term. Now that its expiry is in sight, rumours are starting about a possible extension of this scheme, which comes with a handy acronym: TLTRO.

Getting to Know TLTRO

Targeted longer-term refinancing operations (TLTRO) are a tool for the ECB to provide cheap finance to eurozone banks. They are designed to help lower banks’ marginal funding costs and encourage lending to firms and households in the euro area. A first series of TLTROs was announced on 5 June 2014 and a second series (TLTRO II—into which the remaining TLTRO I was rolled over) on 10 March 2016.

The TLTROs are “long-term” as they run for periods of up to four years. They are called targeted operations because the amount that banks can borrow from the ECB is linked to their loans to non-financial corporations and households. Also, in TLTRO II, the interest rate that the banks pay to the ECB depends on their lending patterns. Banks that issue more qualifying loans benefit from more attractive interest rates on their TLTRO II borrowings. And if they lend enough to the real economy, they can even receive interest by “paying” a negative rate, which can be as low as the ECB deposit facility rate (currently at –0.4%). *

Although the TLTRO II tranches will not start to mature before June 2020, their benefit will disappear earlier. That’s because banks are not allowed to count any funding with less than one year to maturity for some regulatory measures of liquidity. As we approach June 2019, pressure will begin to build on the most exposed banks with the least ability to refinance on good terms in the open market.

So, will the ECB launch TLTRO III? There’s already market speculation building that a new cycle is needed to provide unlimited liquidity to those banks that need it. Italian banks would benefit most, by avoiding a potential funding squeeze resulting from rising Italian Government Bond (BTP) yields.

Which Banks Need TLTRO III Most?

Italian Banks’ Exposure to TLTRO II

Second and Third Tier Banks Are Most Exposed Relative to Their Total Assets

Italian Banks’ Exposure to TLTRO II

As of 31 December 2017
Banks shown are a sample set of TLTRO II borrowers and not a comprehensive listing of all Italian banks.
Historical and current analyses are for informational purposes only.
Source: Individual banks’ reporting

Italian banks have relied heavily on TLTRO II, borrowing 35% of €722 billion in total (Display above). By comparison, other European banks have much lower exposures to TLTRO, and only one (Portugal’s Novo Banco) has an exposure versus total assets of over 10%.

While the biggest Italian lenders (Intesa, UniCredit) have borrowed large nominal balances, the smaller banks are on shakier ground. The second and third tier Italian banks have the greatest relative TLTRO exposure to total assets (and total funding). If they had to refinance and substitute other forms of funding (e.g. deposits, other bank repo, bonds or other ECB programmes such as Main Refinancing Operations—MRO) they would be forced to pay higher rates. This would erode their profit margins.

Even worse, if they couldn’t find alternative funding sources, they could be forced to cut lending. This would undermine TLTRO’s premise, which is designed to reduce borrowing costs for domestic corporates and households.

A High-Stakes Poker Game

The TLTRO conundrum comes at a critical juncture for the region. Political pressures are mounting in Italy and the BTP yield spread over German Bunds is widening. Since the euro crisis in 2011, foreign investors have been reluctant to hold more BTPs. As a result, the burden of financing new government issuance has fallen entirely on domestic investors—including Italy’s banks (Display, below).

Italian Government Debt Is on the Rise

But Foreign Investors Are Reluctant to Buy

Italian Government Debt Is on the Rise

As of 30 June 2018
Historical and current analyses are for informational purposes only.
Source: Haver Analytics (Italian National Accounts)

This linkage between the sovereign’s debt and its domestic banks makes investors justifiably nervous. Italy’s new populist government is threatening to defy the EU’s budget rules and run even bigger deficits in future. Any move higher in BTP yields translates to mark-to-market losses for the banks, hurting capital buffers and reducing credit growth. In this context, two big questions remain unanswered: will a new TLTRO from the ECB be used as a bargaining chip in the EU’s poker game with Italy over its budget deficit? And will the ECB roll its loans over into a TLTRO III if Italy is prepared to cede action on the budget?

Playing Your Hand Well

As the clock ticks down to TLTRO II’s expiry, and with every round of the Italian political game, we expect fresh bouts of volatility—although the systemic impact should remain limited. European banks’ fundamentals generally have improved over recent years and we believe their subordinated debt—in particular Additional Tier 1 (AT1)—looks attractive now. AT1s offer a high yield** and attractive value relative to other parts of the banks’ capital structure. We believe investors should focus more on those banks with relatively strong fundamentals and coherent business models (e.g. the more defensive stories).

Valuations Have Become More Attractive

AT1 Spread Has Widened 85% Since the Tights of 2018, and Is Now Close to the Historical Average

Valuations Have Become More Attractive

As of 15 November 2018
Historical and current analyses are for informational purposes only.
Source: Bloomberg Barclays

However, valuations for each specific bank remain crucial, and looking at the relative value within each bank’s capital structure is very important. For example, when we look at the Italian banks we think that the largest ones will be able to navigate this environment. But in their case, given increasing uncertainty, the higher quality Tier 2 debt offers better value than their AT1.

Because subordinated bank credits—particularly AT1—are complex and need expert analysis to value, they can frequently be mispriced. This can create exceptional opportunities for skilled active investors in turbulent times.

*Source: European Central Bank

** The Bloomberg Barclays Euro Contingent Capital Index yielded 7.06% as of 22 November 2018.

Source: AllianceBernstein.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time.

AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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