Europe fires a big bank bazooka

European banks' strong motivation to use new ECB credit lines is good news for the region, but it may be tempered by tough new banking regulations.

Have European politicians decided to give their banks the job of easing the region’s roiling debt crisis?

That’s increasingly the view of investors after last week’s move by the European Central Bank to provide unlimited three-year loans to banks at a 1 per cent interest rate. The ECB’s move means that European banks will be able to avoid rationing loans to businesses and consumers. But it also gives them a limitless supply of funding to buy up government debt, particularly the bonds that Italy and France need to issue in coming months.

The boss of the Bank of France, Christian Noyer, was quick to describe the ECB’s new deal for the banks as a "bazooka” which should help lower borrowing costs for troubled eurozone counties. "These measures are a spectacular reinforcement of bank liquidity over a long period’, he said in a television interview.

French President Nicolas Sarkozy has also praised the ECB’s actions, saying they were necessary to avoid a "credit crunch” that could have led to an economic depression in Europe. In an interview with the French newspaper Le Monde, Sarkozy added "I hope that the ECB’s action, in supporting economic growth, will also help ease groundless fears over government debts.”

Of course, the banks themselves will not fail to see the advantages of using the new ECB facility to buy government bonds. They’ll be able to borrow funds at 1 per cent, and use the proceeds to buy Italian government bonds that are currently yielding just over 6.5 per cent, reaping an attractive margin of 5.5 percentage points. Alternatively, they might buy Spanish 10-year bonds, currently yielding 5.7 per cent, and earn a handsome 4.7 percentage point margin. If European banks become heavy buyers of government bonds, countries such as Italy and Spain will likely see their bond yields fall significantly, which will reduce their borrowing costs and ease their budgetary pressures.

At the same time, banks will be able to use these fat margins to help rebuild their profitability, and to replenish their depleted capital bases, without having to call on shareholders. This is an extremely attractive proposition for the European banks, which have been set the onerous task of coming up with close to €115 billion ($US150 billion) in fresh capital within the next six months.

As a result, European banks have a strong motivation to make full use of the new ECB credit lines. The only thing that might temper their enthusiasm is the fact that Europe is in the process of introducing tougher banking regulations. The latest stress test by the European Banking Authority required banks to write down their holdings of eurozone government bonds to their market value, rather than simply holding them at full book value. In addition, the ECB could well decide to introduce some limits on their new credit facility if the banks become too greedy for credit.

As a result, the banks will likely show some restraint when it comes to using the ECB’s new liquidity facility. Indeed, what we’re likely to see is that European banks use ECB credit lines to buy the bonds of their own countries, with French banks buying French bonds, while Italian banks buy Italian bonds. This will partly reflect political pressure, as politicians ramp up the pressure on the banks to support their local bond markets. But it also reflects an increasing risk consciousness on the part of the banks themselves. If the euro ever implodes, Italian banks know that it would be better to own Italian bonds, rather than Spanish or Portuguese bonds which carry unpredictable currency risks. In contrast, Italian bonds would be redenominated into new lira, and would be readily accepted as collateral by the Bank of Italy.

As the investment advisory firm GaveKal notes in its latest newsletter, the ECB’s new credit lines will gradually re-nationalise Europe’s banking systems and sovereign debt structures. "This process will help Club Med countries avoid sovereign debt defaults, but it will make eventual breakup of the euro much less painful – and therefore more likely.”