OREANDA-NEWS. Italian and Spanish banks were the largest net takers of the targeted longer-term refinancing operations (TLTRO II) allotted by the ECB on 24 June 2016, which highlights their drive to optimise funding costs in an effort to support margins, says Fitch Ratings.

The domestic operations of Italian and Spanish banks continued to report weak performance metrics in the first months of 2016, with results still weighed down by margin compression reflecting low interest rates, muted lending volumes, high levels of non-performing assets, pricing pressure on loans and poor financial markets performances, among other factors. The TLTRO II programme provides free funding and could help support banks' net interest income.

In our view, the search for cheaper funding is more pressing for southern European banks because their wholesale funding costs are high compared to northern European peers. Based on figures reported by the media, banks fell short of taking up their full TLTRO II allocation; this suggests they are using ECB liquidity to drive funding costs down. Banks have until March 2017 to access TLTRO II funding and take up in later auctions could vary.

Borrowing terms under the TLTRO II programme could be even more favourable for those banks that exceed their lending benchmarks, as these can borrow at the ECB's deposit facility rate, currently negative at -0.4%. Northern European banks have accessed lower volumes of TLTRO funding than Italian and Spanish peers. But these banks might be more capable of meeting their lending benchmarks because they operate in more highly rated countries where asset quality is generally healthier. If banks in these countries identify attractive new lending opportunities, they could be among the first to benefit from the ability to borrow from the ECB at negative rates, which would support profitability because competition for good business is fierce.

Total ECB TLTRO II allotments were EUR399.3bn, but net new liquidity released into the market was a far lower EUR32bn because eurozone banks took advantage to refinance EUR368bn of more expensive TLTRO funding drawn down in prior years. The largest net takers were Spain's BBVA (EUR10bn), Unicredit (EUR8.4bn) and Intesa Sanpaolo (EUR8bn), according to figures reported by the media and the banks.

Brexit-related financial market volatility and the possibility of a significant economic adjustment in the UK are key downside risks for the eurozone economy and if credit demand slows, so might eurozone banks' take up of future TLTRO funding. However, as credit spreads widen for certain banks, their appetite for cheap funding might remain strong.