Tuesday, March 20, 2012

Second Round of LTRO and Volatility Connectedness

The European Central Bank completed the second round of its long-term refinancing operation (LTRO) at the end of February. In the second round the ECB lent another 500 billion to Eurozone banks, increasing total funds used by European banks to 1 trillion.
The second round of LTRO had its impact on financial markets.  With the expectation of the second round, the market sentiment improved significantly in February. As a result, the total volatility connectedness across 14 major European banks declined. On February 14, two weeks before the second round of LTRO was completed, the index hit the lowest level in more than two year, 71.8%. The index fluctuated between 72% and 73% for three more weeks, including the week of March 5-9.
Certainly, the decline from close to 90% all the way down to slightly above 70% shows that the ECB has been following the right policy mix by providing unlimited liquidity to European banks.  However, it is important to note that much of the gains, measured by the decline in connectedness index, accrued in the first round. In the first round, the index declined by 9.4 percentage points, from 84.9% on December 1, 2011 to 75.5% on December 30, 2011. Compared to the first round the impact of the second was rather limited.  In the second round, the decline in the index was not more than 3.5 percentage points. 
This comparison definitely shows the limits of the effectiveness of liquidity operations such as LTRO. Furthermore, the behavior of the index over the week of March 12-16 is a more serious warning to those who thinks that things will be smoother in the near future.  The index lost much of the ground it gained in the week of March 12-16, reaching 75% as of March 16. 
The Eurozone debt crisis is not part of the history, yet.   Banks still carry huge sums of sovereign debt as part of their assets.  The ECB’s LTRO has provided a breathing space for the Eurozone economy.   Unless the EU leaders agree on a permanent solution this spring, the next episode of the Eurozone debt crisis is likely to take place in 2012.