02/12/2012 02:29 pm ET | Updated Apr 13, 2012

Is the European Central Bank Playing With Fire?

In a few days, European Banks will be given the opportunity to borrow an unlimited amount of money from the European Central Bank (ECB). The maturity of the loans is 3 years and the rate of interest is... 1 percent while banks borrow above the Euribor rate close to 2 percent for three years. A similar transaction was launched in December and allowed banks to collect $650 billion at those below market rates (assuming there is a market for three year loans). According to the Financial Times, European banks are expected to borrow twice that amount.

Serious observers expressed concerns on the actual size of the balance sheet of the ECB after that transaction. Assuming that the new transaction adds $1.3 trillion to the ECB balance sheet as announced, it would reach $5 trillion, while the current Federal Reserve size is at $2.9 trillion.

The transaction is far from having been unanimously approved by the European Central Bank Board and Germany is deadly against it. The ECB President has encouraged the banks to borrow while Deutsche Banks' President, Joseph Ackermann, rightly expressed some concerns that banks who will rely on this borrowing will be stigmatized. As a "lender of last resort" the ECB should only act in... last resort and not facilitate the liabilities management of European banks.

Never in the history has so much money been poured in the direction of banks, most of which don't need it. It is becoming clear that European banks will use it, not to boost the economy, but to manage their balance sheet and offload high-interest borrowings and replace them with this below market.

Furthermore, concerns exist also at the quality of the collaterals deposited by banks. The ECB has indeed to relax its criteria to be able to lend such large amounts to banks.
Furthermore, the ECB does not have a funding ability that would match the cost of lending: its balance sheet largely relies on short term deposits by central banks and other public institutions, as well as private banks. It is mismatching its own treasury and might end up with borrowing costs higher than the 1 percent interest rate of the $2 billion it will have lent to banks.

With $100 billion of Tier 1 equity, the ECB is the most leveraged central bank, with 2 percent of equity/debt ratio. Even by adding a $175 billion of "asset revaluation", it is way below the 9 percent Basel III ratios of the banks.

A commercial bank who would have increased its balance sheet by 100 percent in two years, accepted to lower the quality of its collateral, mismatched the treasury of two thirds of its funding and inadequate capitalization would probably be close to bankruptcy.

Yet, the European Central Bank will not go bust. It is backed by the Governments and therefore the European taxpayer. The $5.5 trillion, however, will never appear in the public debt numbers.

Looking at the ECB situation, the new $1.3 trillion loan should at least be decreased if not abandoned. Yet, the ECB is not the most guilty party: European Governments have literally dumped on it assets that were not worth their nominal value: It owns $ 65 billion of Greek debt and refuses to write off the 70 percent that private banks will have to accept.

The ECB is paying with its creditworthiness, and so do the Governments of the European Union. Can it be stopped before it is too late?