Can the ECB avert catastrophe?

The ECB's loan program has helped avert a global liquidity crisis, but concern is growing that European banks are overdependent and will struggle when the cash needs to be repaid.

Financial markets, which are now severely addicted to central bank money printing, suffered a bout of disappointment overnight after US central bank boss Ben Bernanke signalled that he wasn’t in a hurry to start a new round of bond buying.

This disappointment came after an earlier bout of relief, after the European Central Bank again cranked up the printing presses overnight and provided 800 European banks with €529.5 billion ($US705.7 billion) in ultra cheap, three-year loans.

The second round of the ECB’s loan program (officially known as the long-term refinancing operation, or LTRO) was higher than the initial offering in December last year, which saw 523 banks pick up €489 billion. Since December, the ECB has broadened its collateral rules, which meant that smaller banks were also able to participate in last night’s offering.

Last night’s offering means that the ECB has now provided European banks with more than €1 trillion of three-year loans at the ultra-cheap interest rate of 1 per cent.

So far, the ECB’s LTRO program has managed to reduce the funding strains that many European banks were facing, which has helped avert a liquidity crisis in the global banking system. It has also largely eliminated the risk that a bank could default on payments because it ran out of money, and it has reduced the pressure on banks to sell off huge swathes of assets to lessen their funding needs.

Many European banks are expected to use their LTRO to refinance the €700 billion in bank debt that matures this year.

More importantly, banks – especially Spanish and Italian banks – are likely to use their latest batch of LTRO funds to buy up their governments’ bonds, which will help push Spanish and Italian bond yields lower. The banks also earn a handsome spread between the 1 per cent they pay on their LTRO loans and on the Italian and Spanish government bonds they buy, which helps boost their profits, and rebuild their capital levels.

Although the ECB doesn’t release the identities or the nationalities of the banks that borrowed, Spain, Italy and France are believed to have taken up two-thirds of the latest round of funding.

Spanish banks bought €23 billion of national bonds in January while Italian banks bought €21 billion. In December and January combined, Italian banks increased their bond holdings by 13 per cent to €280 billion, while Spanish banks’ bond holdings jumped by 29 per cent to €230 billion.

As a result, LTRO is leading to an effective renationalising of the government debt of Italy and Spain, with banks holding an increasing portion of their governments’ debts. This reduces the likelihood of a systemic European banking crisis should either of these countries eventually be forced to leave the eurozone.

But the LTRO program is coming under increasing fire. Many argue that it’s allowing banks to become overdependent on ECB funding, and they worry that the European banking system could face a crisis in three years’ time when the money needs to be repaid.

Others point out that banks that borrow from the ECB will be increasingly stigmatised, with other banks shying away from lending to banks that have made heavy use of the ECB facility. Because the ECB ranks ahead of other creditors, loans from other banks effectively become subordinated. What’s more, there’s little evidence that the banks are using their LTRO funds to lend to European companies.

And southern European banks are likely to become even more dependent on ECB funding as the capital outflow from southern eurozone countries accelerate. Wealthy individuals in countries such as Greece, Spain and Italy have become increasingly concerned that their countries might eventually be forced quit the eurozone and to adopt their former currencies. This would mean their savings would be severely eroded.

As a result, they’re trying to protect their savings by opening bank accounts in Switzerland, or buying up properties in major cities such as London.

According to data released this week by the European Central Bank, deposits in Greek banks plunged by 17 per cent last year. Other debt-plagued countries have also noted declines. In Ireland, deposits fell by 6 per cent, while in Spain it was almost 3 per cent and in Italy it was just under 2 per cent. In comparison, deposits in Germany last period climbed by 3 per cent while French deposits soared by 10 per cent.