Long-Term Refinancing Operations

The financial sector is famous for its acronyms, from CPA to CDS, and new terms seem to spring up with each financial innovation or crisis. During the European sovereign debt crisis, the acronym LTRO was coined to represent "long-term refinancing operations." These were loan products used by the European Central Bank (ECB) to lend money at very low interest rates to eurozone banks.

How LTROs Work to Support Growth

LTROs provide eurozone banks with a source of low interest rate funding in times when cash, or liquid funds, are low. As collateral on these loans, banks can use sovereign debt. The loans are offered monthly, and the most common forms are to be repaid in three months, six months, or one year. In some cases, the ECB used longer-term LTROs. The three-year LTRO in December of 2011 was one such instance of these longer versions, which tend to see much higher demand.

The LTROs are designed to have two major impacts:

• Greater bank liquidity: When banks have access to cheap capital, they can lend more money, which in turn spurs economic activity. Greater access to cash also allows them to invest in higher-yielding assets in order to generate a profit. This helps banks with cash flow trouble to improve their balance sheets.
• Lower sovereign debt yields: Eurozone countries can use their own sovereign debt as collateral, which has the effect of increasing demand for their bonds and lowering yields.

LTROs themselves are conducted via a fairly standard auction format. The ECB decides on the amount of liquidity that is to be auctioned. It then asks banks for express interest rates. Interest rates can be set by either a fixed rate tender or a variable rate tender, where banks bid against each other to access the available liquidity.

LTROs During the European Debt Crisis

LTROs became common during the European financial crisis that began in 2008 and lasted for about three years. Before the crisis hit, the ECB's longest tender offered was for just three months. These early LTROs amounted to just 45 billion euros, which made up about 20% of the ECB's total cash loans. As the crisis evolved, these LTROs grew to offer much longer terms, and also became larger in size.

During the sovereign debt crisis and the years that followed, LTROs hit a series of milestones:

• March 2008: The ECB offered its first supplementary LTRO with a six-month term. It was bid on by 177 banks, and more than four times oversubscribed.
• June 2009: The ECB announced its first 12-month LTRO. It closed with over 1,100 bidders in sharply higher demand than previous LTROs.
• December 2011: The ECB announced its first LTRO with a three-year term and a 1% interest rate. This was the first loan that used the banks' portfolios as collateral.
• February 2012: The ECB held a second 36-month auction, known as LTRO2. It provided 800 eurozone banks with 529.5 billion euros in low-interest loans.

In 2014, due to the success of these programs, the bank created new versions called Targeted Long-term Refinancing Operations (also known as TLTRO) to further boost liquidity. TLTRO II and TLTRO III followed in 2016 and 2019. They are conducted each quarter, and set to renew through 2022. The aim of the TLTROs is to shore up liquidity and support growth until inflation reaches the desired target levels.

Alternatives to LTROs for Liquidity

The ECB also provides shorter-term repo liquidity measures called Main Refinancing Operations (MROs). They are conducted in the same manner as LTROs, but have a maturity of one week. MROs can be likened to those conducted by the U.S. Federal Reserve to offer temporary loans to U.S. banks during hard times to shore up liquidity.

Eurozone countries can also access liquidity through Emergency Liquidity Assistance (ELA) programs. They are thought of as "lender of last resort" options, to help banks only during times of crisis. ELAs are very temporary. Individual countries can run ELAs, with the ECB keeping the power to override, though they are less common than other forms of assistance.

What It Means for Investors

LTROs can have a major impact on the market depending on their duration and size. Often, the market will react positively when unexpectedly large measures are announced since the move tends to increase liquidity and bolster the financial system.

Despite the short-term gains, the long-term impact on these operations is up for debate. It is not certain how these programs affect the market in the long term, and the impact on investors may vary.