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Long-term refinancing operations are back! Historically, central banks have used a long-term refinancing operation (LTRO) as a way to allow banks to borrow against their assets during credit crises.

In a LTRO transaction, a central bank makes short-term, asset-backed loans to commercial banks. For example, a European bank may agree to a LTRO with the ECB in which it gives the ECB collateral in the form of securities and receives cash as a loan from the ECB.

How LTROs Affect Sentiment

Long-term refinancing operations have become a barometer for banking health. We know that the European Central Bank, for example, has a LTRO in place for member nations and banks. Thus, based on the level of borrowing from the European Central Bank’s LTRO, we can determine how difficult or easy it is for banks to get credit.

• If banks are borrowing a lot of money from the LTRO, the banks obviously cannot find credit less expensive (or in ample quantities) in other markets.
• If banks do not borrow a lot of money from the LTRO, then banks are either well-capitalized, or they have found other ways to finance their immediate needs.

European LTRO

The European Central Bank currently has an open LTRO in place for member banks in nations using the Euro. The LTRO program was first opened in December 2011, with additional funding made available in March 2012.

So far, the biggest users of the long-term refinancing operation have been Spanish banks. MarketWatch reports that Spanish banks have borrowed roughly 40% of all LTRO capital made available in the March period.

This shows weakness on behalf of Spanish banks, many of which are heavily invested in Spanish government securities. The same articles notes that it is believed Spanish banks collected billions of euros in low-interest LTRO loans from the Eurozone while increasing their holdings of Spanish government debt. Such a move would increase the banking system’s risk to a default by the Spanish government on its debt issues.

In the initial round of borrowing in December 2011, the ECB loaned 489 billion euros to 523 banking institutions. The second round in March came in much larger to the tune of 529.5 billion euros loaned to 800 different banks.

Both rounds of LTRO easing were issued in loans with 3-year maturities and an annual interest rate of 1%.

LTRO vs. Quantitative Easing

LTRO is different from quantitative easing or QE in that the capital from LTRO flows directly to banks. In a Long-term refinancing operation, the central bank loans to commercial banks, which use the funds to make loans to individuals and governments. In quantitative easing programs such as those enacted by the Federal Reserve, the central bank buys government debt on the open market to drive down rates.

So, in effect, LTRO makes capital available directly to banks at a rate often lower than the market rate of interest. Quantitative easing makes capital available to the government directly, and has the greatest effect on the public rate of interest.

In either case, both LTRO and QE programs by central banks inflate currency stockpiles and ultimately drive down the value of individual currencies.