ECB fattens up Europe's banks with cheap loans

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The European Central Bank's massive injections of liquidity into the banking system may have handed the lenders a reprieve but seems to have done little to sate the ailing economy's desire for business-boosting credit.

European banks on Wednesday gorged themselves on €529-billion ($698-billion) of cheap ECB loans. The money was lent at 1 per cent over three years to 800 banks. The last auction, in December, saw €489-billion fly out of the ECB's doors to 523 banks.

The loans, known as the long-term refinancing operation (LTRO), were introduced by ECB president Mario Draghi late last year to prevent a Lehman Bros.-style banking collapse on home turf as the interbank lending market dried up.

While the ECB, under Mr. Draghi's predecessor, Jean-Claude Trichet, had hosed out cheap loans in the past, those were short-term loans. The new three-year loans give the banks unprecedented financing security.

There's little evidence, however, that another of the ECB's aims – bailing out struggling businesses – has been achieved. Data released by the central bank earlier this week show that lending to businesses remains moribund. In December, lending fell by €35-billion. The latest figures, from January, show a €1-billion drop from December. The good news is that the December data show signs of stabilization, even if it is down slightly.

Mr. Draghi hopes the new instalment of the LTRO will pump up the loan volume. The far higher number of banks taking ECB loans on Wednesday increases the chances of more lending, though far from guarantees it.

The December LTRO was widely credited with triggering a bank rally and yanking down soaring yields on the sovereign bonds of highly indebted countries, such as Italy and Spain (if not Portugal).

That's because the banks, under the urging of French President Nicolas Sarkozy, used some of the loans to buy government debt. The so-called "carry trade" has the potential to produce fat profits for the banks: They borrow at 1 per cent to buy government bonds that may yield 5 per cent or more. Those bonds, in turn, can be used as collateral at the ECB.

The greater number of banks involved in the latest LTRO is a direct reflection of the ECB's decision to broaden the pool of collateral that can be swapped for the ECB loans.

Economists generally put a positive spin on Wednesday's auction.

Martin Van Vliet, of ING Financial Markets, said: "In our view it is a Goldilocks outcome: Not overly large as to generate concern about the fragility of the European banking system, but high enough to prefund a substantial share of maturing bank debt and spark more buying of Italian and Spanish paper."

Mr. Draghi's twin LTROs were designed to add liquidity to the banks at a time of financial stress; give them reserves to cover hundreds of billions of euros of bank debt maturities between now and 2014; provide them profit from the carry trades; and encourage loan growth, especially to small and medium-sized companies that are having trouble staying in business because banks are reining in their loan and credit portfolios.

The first LTRO failed in that sense; the banks, still afraid to lend to one another, used the loans to repurchase bank bonds or simply re-deposit the funds at the ECB.

As of Tuesday, the banks had deposited a record €481-billion at the ECB even though ECB balances pay a mere 0.25-per-cent interest.

Mr. Draghi on the weekend acknowledged that it was "hard to say" whether the first LTRO had boosted loans to the euro zone, which is expected to contract by 0.3 per cent this year, in part because businesses that are having trouble gaining bank loans are shedding employees.

But he was optimistic that banks would change their tight-fisted stance and extend more credit to the economy.

"One expectation now is that having satisfied their funding needs for this year, at least the banks will be more inclined to use the money – which was our prime expectation really – to expand credit to the real economy," Mr. Draghi said. "We have certain aspirations and ambitions that what we do actually helps the real economy, and we will see what happens."