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Dec 31st 2011 | BERLIN | from the print edition
Many a slip twixt pump and nozzle
WHEN economists think of the financial system, it is usually as a frictionless
conduit through which money flows to areas of the economy where it is most
needed. A better analogy right now might be of a hosepipe with a knot tied in
it. The European Central Bank (ECB) is pumping unprecedented amounts of money
into one end of the pipe, but how much of that will find its way to the parched
real economy is another question entirely.
Start with the liquidity flowing into the euro-area banking system. On December
21st the ECB made available an eye-popping 489 billion ($628 billion) in
three-year loans to more than 500 banks across Europe. The money was released
in response to an almost total freeze since July in the bond markets that are
an important source of long-term funding for banks. Demand for this ECB funding
was much higher than expected, signalling just how much stress there is in the
system.
The ECB had previously tried to ease pressure by offering one-year loans to
banks. Yet this had done little to encourage them to lend to companies or
people, since the money banks owed the ECB would have to be repaid before they
were due to be repaid by their customers. A shortage of longer-term funding
also contributed to an increase in the riskiness of the whole financial system,
since banks were being forced to rely ever more on short-term financing that
needs to be rolled over.
The flood of money being pumped into banks by the ECB goes a long way towards
easing these funding pressures. Analysts at Morgan Stanley, an investment bank,
reckon that the new facility adds about 235 billion in additional funding to
the banks (since some of the money is being used to replace shorter-term loans)
and takes the central bank s total lending to the banking system to 979
billion. More important is the fact that it only has to be repaid in three
years, which takes the average maturity on ECB loans to about 21 months, up
from a mere ten weeks before the auction.
This should help insulate most large banks from turmoil in the funding markets.
But not all will be protected. Although the ECB has essentially made an offer
of unlimited funds, banks are still constrained in how much they may borrow by
the quality of the collateral that they are able to hand over. This is because
their collateral is subject to an initial haircut , or reduction in value. A
portfolio of relatively safe government bonds might attract a small haircut,
whereas one consisting of loans to small businesses might be reduced in value
by 40% or more. A bank focused on this area of business, as many of Europe s
smaller savings banks are, might thus only be able to borrow 60% of the value
of its outstanding loans.
A second constraint is that if the collateral the ECB holds falls in value,
then banks need to post more. This also happens if there are credit downgrades
on the bonds posted as collateral. The ECB s haircut on sovereign bonds that
are rated above A- is just 1.5%, but if they fall another notch this jumps up
to 6.5%, Morgan Stanley notes. Weak banks in peripheral countries remain
vulnerable to a downward spiral in which their holdings of government bonds are
downgraded and fall in value, forcing them to come up with ever more collateral
to keep borrowing from the central bank. It was this sort of collateral spiral
that felled MF Global, a bust American broker, in its ill-fated bet on
euro-area government bonds.
Now that banks are getting funding, the big worry is whether they will do more
than merely hoard it. The early signs are not encouraging. Over the Christmas
weekend bank deposits at the ECB rose to a record 412 billion. That partly
reflects a traditional year-end rush to tidy up banks balance-sheets but also
nervousness about lending directly to others.
Banks also have to present plans in January showing how they will raise an
extra 115 billion in core capital to meet a new threshold imposed by the
European Banking Authority. This capital shortfall has already prompted asset
sales by banks, which would rather shrink their balance-sheets than tap
shareholders. The ECB s auction may make a credit crunch less severe, but it is
not enough to avoid one.