Analysis: Draghi comments spur guesses on ECB liquidity exit

By Emily Flitter

LONDON (BestGrowthStock) – The European Central Bank’s desire to stop directly funding ailing euro zone banks is fuelling financial market speculation that it may consider a vehicle where banks can park toxic assets.

This option, and any others that may be under consideration, will have to ensure an eventual exit from easy monetary policy does not trigger a scramble for funding from weaker banks that results in artificially high money market rates.

The search for solutions was flagged by ECB Governing Council member Mario Draghi in Friday’s Financial Times. He said the ECB wanted to “make absolutely sure that our monetary policy is not going to be polluted by the addicted banks’ demands.”

Draghi said the ECB was considering concrete policies to break banks’ addiction but gave no details.

Whatever option is chosen, analysts say the ECB will be keen to pitch the responsibility for helping ailing euro zone banks back to individual countries.

“The circuit breaker to the problem really is the recapitalization of the individual banks, and that’s not something the ECB can do,” said an interest-rate strategist at a major investment bank.

“They have to press the individual countries’ financial regulators to do it.”

Banks’ reliance on the ECB remains strong. The central bank lent banks in Ireland, including foreign banks there, 136 billion euros up to November 26, two days before a European Union/ International Monetary Fund bailout for Dublin was sealed.

Jens Larsen, chief European economist at RBC Capital Markets in London, said the ECB’s best bet was to help set up a longer-term funding facility for the struggling banks, similar to the one in place in the UK, in which banks can park bad assets in exchange for treasury bills.

The banks would retain the bad assets’ credit risk, thus protecting the ECB or individual countries’ balance sheets from more damage.

This facility could be run by the ECB or by the individual countries, Larsen said.

“That would provide a solution with features adjusted for that specific country,” he said.

Hiving off banks’ non-performing assets is not without risk.

When Ireland announced a bad bank scheme in which it took its ailing banks’ toxic assets onto its own balance sheet, government debt yields spiked, adding to pressure that led to the 85 billion euro bailout.

Gilles Moec, co-head of economic research at Deutsche Bank in London, said the ECB could use new powers to allow it to selectively limit individual institutions’ access to funding.

Before the rule change in October, institutions could either opt for unlimited funding or no funding at all.

But with its new powers, the ECB could force banks to be more competitive in their bids for funds, meaning they would have to turn to their own governments to make up the difference.

This could create a conundrum for European debt markets. If struggling countries had to recapitalize their banks, their deficits could rise.

But analysts said the markets would, in the end, support countries that took on the burden of their troubled banks.

“If Spain were to announce a program tomorrow to recapitalize banks and the sovereign were to underwrite it, the market would support it,” the London-based interest rate strategist said.

He said the ECB could begin to tighten collateral requirements for loans.

It loosened the requirements in June, when Greece’s sovereign bonds were downgraded below investment grade and banks still needed to use them as collateral for ECB loans.

Market participants did not see an immediate ECB move, but said the ECB would wish to act soon.

“The liquidity issue is a constraint on the ECB’s policy implementation: they are not in a rush to tighten rates right now, but they want to be able to do so later,” Larsen said.

“So they don’t want the liquidity issue to go unaddressed for long.”

(Editing by)

Analysis: Draghi comments spur guesses on ECB liquidity exit