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European Central Bank Lends Record $639 Billion To Banks Over 3 Years

European Central Bank

DAVID McHUGH   12/21/11 03:56 PM ET  AP

FRANKFURT, Germany — Struggling banks snapped up euro489 billion ($639 billion) in cheap loans from the European Central Bank on Wednesday, a sign of just how hard or expensive it has become to borrow from each other.

The huge demand for newly available three-year loans comes as fears rise that heavily indebted European governments could default and force banks and other bond holders to take big losses.

The loans to 523 banks surpassed the euro442 billion ($578 billion) in one-year loans extended in June 2009, when the global financial system was reeling from the collapse of the U.S. investment bank Lehman Brothers. It was the biggest ECB infusion of credit into the banking system in the 13-year history of the euro.

The ECB wants banks to use the money to help pay off or refinance some euro230 billion ($300 billion) in existing loans early in 2012. Without the special support from the ECB, banks would have had to cut back on loans to businesses and further squeeze the European economy.

While the loans will help stabilize banks and make it easier for them to lend to businesses, they do not attack the root of Europe's financial crisis – heavily indebted governments face unsustainable borrowing costs. Many economists believe that to solve that problem the ECB needs to become the lender of last resort to European governments, buying up their bonds in large quantities in order to lower their borrowing costs. ECB President Mario Draghi has said governments should not depend on a central bank bailout.

Markets initially rose after the amount of the ECB borrowing was announced; it was far higher than the euro300 billion ($392 billion) expected. But the optimism faded as investors weighed the broader problems facing Europe's economy and financial system. The broad Stoxx 50 index of European shares fell 0.5 percent. Indexes in Germany and Italy closed about 1 percent lower. The euro fell nearly 2 cents, to $1.3023 from $1.3198 earlier Wednesday. U.S. stocks traded lower as well.

"The good news is, the ECB's efforts to increase liquidity are working," said Jennifer Lee, an analyst at BMO Capital Markets. "The bad news is, high demand for the loans creates worries that banks are urgently in need of funds to boost liquidity."

There was some speculation that the loans could indirectly help governments. In theory, banks could borrow from the ECB at an interest rate of 1 percent and then use that money to lend at much higher rates to European governments.

But many analysts think it was unlikely that banks would increase their exposure to government bonds, given ongoing fears of a possible default among troubled eurozone nations. Many banks have struggled to cut their holdings of debt from governments in financial trouble.

"We still believe it is difficult to reconcile a government desire for banks to continue buying debt with the need for banks to reduce risk exposure associated with government debt," said Chris Walker, an analyst at UBS.

Many economists think that the eurozone is heading toward at least a mild recession. Data released Wednesday showed that Italy, the eurozone's third-largest economy, contracted 0.2 percent in the third quarter.

The deeper the economic slowdown is in the eurozone, the more tax revenues may suffer – and the harder it will be for Europe's indebted governments to handle their debt loads.

Italy and Spain have been at the center of investor concerns in recent months as their borrowing costs have risen amid concerns over their debts. Both are considered too big to bail out with the current eurozone bailout funds, which have some euro500 billion ($654 billion) in financing.

A default on debt payments by either could ignite a new financial crisis and send the global economy into a slump.

Some of that European rescue money is already committed to bailouts of smaller Greece, Ireland and Portugal, which needed outside financial help after default fears drove their borrowing costs to unsustainable levels.

Italy alone has some euro1.9 trillion ($2.5 trillion) in outstanding debt.

In making the loans, the ECB was playing its role of supplier of liquidity to banks, a typical job for central banks.

ECB president Mario Draghi has stressed the central bank's role in supporting the banking system but has balked at suggestions it should be offering the same level of support for indebted governments themselves by buying up their risky bonds. Draghi says governments must be the ones to reduce their spending and deficits.

The 37-month term of the loans permits the banks to stock up on money for a much longer period and reduces stress on their finances. Draghi has said the extra-long credit period will allow banks to lend for longer periods and not cut credit to businesses.

Alongside efforts to shore up banks, the ECB has also been cutting interest rates to support the ailing eurozone economy. It has reduced its main refinancing rate from 1.5 percent to 1.0 percent over the last two months in the hope that lower borrowing costs will stimulate growth by making credit cheaper.

Under the terms of Wednesday's loans, the banks will pay the average refinancing rate over the three years. The ECB reviews the rate each month and it will almost certainly change. Banks also have the flexibility of repaying the money after a year if their situation improves. Wednesday's offering was the first of two that the ECB has planned.

European officials have said banks need to raise euro115 billion ($150 billion) in new capital in 2012. But finding that money is not an easy task in the current environment of fear. Investors are leery of putting more money into banks and it would be politically unpopular for debt-strapped governments to do it either.

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Filed by Harry Bradford  |