TLTRO III phase-out and bank lending conditions

Prepared by Francesca Barbiero, Alessandro Ferrari and Franziska Maruhn

Published as part of the ECB Economic Bulletin, Issue 8/2024.

From late 2022 to the end of 2024, euro area banks repaid more than €2 trillion in funding from the third series of targeted longer-term refinancing operations (TLTRO III) in a context of rising interest rates, reducing borrowing from the Eurosystem to an all-time low. With the finalisation of TLTRO III repayments and in the context of the higher interest rate environment that emerged from the recent hiking cycle, the liability structure of banks has changed. As banks increased their reliance on securities issuance and deposit funding in relative terms, the liability composition moved closer to that prevailing before the introduction of TLTROs in 2014 (Chart A). At the same time, Eurosystem refinancing operations now represent a smaller share of bank funding than ever before owing to the limited recourse to shorter-term standard refinancing operations, the costs of which are currently well above those of alternative funding sources, and still ample central bank reserves, which are supporting bank liquidity.^[1]

Chart A

Bank liability structure over time

(percentages of main liabilities)

The extraordinary pace at which policy rates increased, combined with market expectations of future rate cuts, made shorter-term central bank refinancing operations less attractive than alternative funding sources, such as deposits and longer-term bonds. Roll-over into currently available central bank financing may also have been limited owing to its significantly shorter maturity compared to TLTRO III and owing to regulatory requirements such as the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR).^[2] Moreover, the still ample central bank reserves imply limited need for banks to resort to central bank funding for the time being. However, as the run-off of the ECB asset portfolio continues, further reducing excess liquidity, demand for central bank funding may increase again. As lending conditions appear to be sensitive to how reserves are supplied to the banking system, the impact of central bank liquidity on bank intermediation will also crucially depend on the instruments providing liquidity in the future.^[3]

The recalibration of TLTRO III in October 2022 brought about the fastest and largest decline in Eurosystem borrowing ever recorded (Chart B) and reinforced the transmission of policy rates to bank lending conditions. Since their inception in 2014, TLTROs have supported the transmission of monetary policy easing by incentivising lending through their targeted nature and by reducing bank funding costs. The third series initiated in 2019 was a key tool of monetary policy accommodation during the pandemic.^[4] In view of the unexpected and extraordinary rise in inflation that started in 2021, the ECB embarked on a path of monetary policy normalisation at the end of 2021 by adjusting asset purchases and, as of mid-2022, increasing policy rates, which led to tighter financing conditions for the euro area economy. In this context, the Governing Council also decided to recalibrate TLTRO III in October 2022 to reinforce the transmission of higher policy rates to bank lending conditions. Specifically, the interest rate on remaining TLTRO III amounts was increased from 23 November 2022 onwards.^[5] The higher TLTRO interest rates raised the opportunity costs of TLTRO funding. At the same time excess liquidity remained abundant and the benefits of TLTROs for fulfilling liquidity and stable funding requirements decreased as the operations approached maturity. Therefore, at the first opportunity for voluntary early repayments since the recalibration, banks repaid €296 billion in November 2022 out of an outstanding amount of €2,113 billion. This was followed by further large voluntary repayments in December 2022 and over the subsequent six months. Thus, the recalibration contributed to a significant frontloading of the TLTRO reduction and smoothed repayments over time compared to what would have been the case if banks had held all TLTRO funds to maturity (dashed line in Chart B).

Chart B

Recourse to Eurosystem refinancing operations

(EUR trillions)

Banks adapted their balance sheets to cover the frontloaded TLTRO repayments, with some banks relying more on their own outstanding excess liquidity, while others raised additional funding in bond markets and via deposits (Chart C). Following the October 2022 recalibration, banks which had borrowed under TLTRO III could be divided into two groups: those which repaid all their TLTRO III borrowing early and those which repaid at least part of their borrowing only at maturity until June 2023 (when the largest TLTRO III operation matured). The two groups differed mainly in their level of reliance on TLTRO III funding and in the size of their excess liquidity prior to the recalibration. Banks which fully made use of early repayment options had on average almost twice as much excess liquidity as their outstanding TLTRO III borrowing prior to October 2022, while banks which also repaid at maturity had on average an amount of excess liquidity that was similar to their outstanding TLTRO III borrowing. Accordingly, the first group of banks reduced their excess liquidity by the equivalent of around 75% of their TLTRO repayments, thus relying primarily on existing excess liquidity, while also experiencing an outflow of deposits (Chart C, panel a). By contrast, the second group of banks raised a significant amount of additional funding to repay TLTRO funds at maturity – predominantly via securities, followed by deposit inflows and borrowing on the interbank market – and only reduced their excess liquidity by the equivalent of around 50% of their TLTRO repayments (Chart C, panel b). The second group also increased their deposit rates more than the other banks, thereby managing to preserve and, to a certain extent even increase, their overall deposit volumes to compensate for the ongoing decrease in central bank liquidity.

Chart C

Changes in bank balance sheets since the recalibration of TLTRO III

(EUR trillions)

The reduction in bank liquidity and the increase in TLTRO rates induced banks to resort to more expensive sources of funding, leading to tighter lending conditions. The TLTRO repayments using outstanding excess liquidity reduced available liquidity positions, while the roll-over into other liabilities increased funding costs. This in turn seems to have led to tighter lending conditions to firms and households. According to survey evidence, banks experienced the first negative impact of TLTRO III on their overall funding conditions after the recalibration, suggesting that the less favourable TLTRO III conditions effectively induced a tightening of bank funding conditions.^[6] Moreover, banks reported a negative impact of the phase-out of TLTRO III on their liquidity positions. This was also reflected in a further tightening of banks’ credit standards for all loan categories and a further slightly negative impact on bank lending volumes in the context of an overall reduction in credit supply due to the policy rate hiking cycle.^[7] In line with this, banks which had less outstanding excess liquidity available to make TLTRO III repayments have also seen a small reduction in outstanding loan volumes since the TLTRO recalibration (Chart C, panel b). Analyses controlling for loan demand and other confounding factors confirm the negative impact of the TLTRO recalibration on lending.^[8] In conclusion, the recalibration further supported the tightening of bank funding costs and, in turn, financing conditions. In addition, it removed deterrents to the voluntary early repayment of outstanding TLTRO III funds, thereby accelerating the reduction of the Eurosystem balance sheet and contributing to the overall tightening of monetary policy.