CORRECTED – ECB FOCUS-New liquidity plan to speed exit from crisis steps

(Corrects to quote source as saying new facility will replace
emergency funding from national central banks, not ECB’s own
money market loans; corrects GMT time of stress tests release)

* Liquidity plan could speed end of ECB’s unlimited lending

* May help it regain control of overnight interbank rates

* ECB’s control of terms of loans has political implications

* May have to be strict with troubled banks to make it work

By Marc Jones and Paul Carrel

FRANKFURT, March 28 (Reuters) – The European Central Bank’s
planned new liquidity facility for Irish and other troubled euro
zone banks could help the ECB end its offers of unlimited loans
in the money market, and finally re-establish its control of
overnight interbank lending rates.

For the last 2-1/2 years of financial crisis, the ECB has
been lending banks all the cash they request. It is now eager to
halt those unlimited loans as the euro zone’s economy recovers
and inflationary pressure mounts.

But it cannot halt them without putting something in their
place, for fear of destabilising banks in weak states such as
Greece and Ireland and forcing them into fire sales of assets.

A central banking source, who revealed the outline of the
ECB’s plans to Reuters on Saturday, said the new liquidity
facility would replace emergency funding currently supplied by
national central banks, outside the ECB’s own money market
operations. (for story, click [ID:nLDE72R087])

It would create a new breed of ECB operation which in return
for giving commercial banks funding security, would permit the
ECB to impose new conditions on banks receiving its money.

These conditions, analysts believe, will help the ECB wean
banks off dependence on its unlimited loans and eventually —
maybe in the next year or so — stop offering such loans.

“If the ECB puts in place the mechanism, it should
definitely accelerate the pace of returning its operations back
to normal,” said UniCredit analyst Luca Cazzulani.

But the facility is likely to be politically sensitive; if
the ECB uses it to micromanage struggling banks, that could
erode the national sovereignty of Ireland and other euro zone
members with banks that use the facility.

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For a graphic of banks’ use of ECB loans by country, click:

http://r.reuters.com/ryj95n

For a graph of bond spreads, click:

http://graphics.thomsonreuters.com/F/09/EZ_DBTPH0210.gif

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DEPENDENCE

Official figures show Irish, Greek and even some German
banks remain heavily dependent on ECB funding. Ireland’s six
domestic banks borrowed 85 billion euros from the ECB last month
while the Irish central bank handed out a record 70 billion
euros in “Emergency Liquidity Assistance”. [ID:nLDE68K0ZH]

Besides distorting banks’ commercial behaviour, the ECB’s
extreme generosity has caused it to lose control of very
short-term interest rates, which are supposed to be a key tool
of monetary policy.

There is so much excess ECB money in the market that the
EONIA overnight interbank lending rate (EONIA=: Quote, Profile, Research) has sunk to
0.635 percent, well below the central bank’s 1.0 percent
refinancing rate. In normal times, EONIA sits just above the
refi rate.

Cazzulani believes using the new facility to reintroduce
limits to ECB lending would see the central bank quickly regain
its grip on overnight rates.

“If you set up something that is accessed only by banks in
need of liquidity, then they would only take what they need —
they would not put it back into the system and you would have no
excess liquidity left.

“This would most likely drive up EONIA towards the level of
the refi.”

NEW POWERS

The ECB facility is expected to be announced formally soon
after the results of stress tests of the health of Irish banks
are published at 1530 GMT on Thursday.

It is not yet known how much discretion the ECB will have to
deny banks access to the facility; this will determine how much
influence the ECB can exert on banks’ behaviour. It is also not
clear how aggressively the ECB will be able to squeeze banks out
of its mainstream lending operations and into the new facility.

Societe Generale economist Klaus Baader believes the euro
zone’s political principles mean the ECB will not be able to bar
individual banks from its mainstream operations. But he thinks
it may revise its mainstream lending rules when it introduces
the facility, in order to limit weak banks’ borrowing.

“I don’t think the ECB could push them out entirely,” Baader
said. “We know the ECB wants to bring an end to the addiction
some banks have to ECB funding, so what they could do is
introduce limits based on the size of the balance sheet.

“Up to your limit you could participate completely normally
(in mainstream ECB operations), but after that they would attach
some conditionality.”

The central banking source told Reuters that the new
facility would allow central bank policymakers to exert greater
pressure on banks by attaching tough terms to the funding.

This could be awkward if the ECB does not handle it very
carefully. Ireland’s centre-right government came to power last
month in an election dominated by anger at the country’s
economic meltdown and the harsh cure prescribed by other
European governments. It will not take kindly to any sign that
the ECB is interfering in an overbearing way with Irish banks.

“From the point of view of the Irish banks, it’s going to be
the ECB way or no way,” said Vanessa Rossi, senior research
fellow at London-based think tank Chatham House.

“At this point, the Irish banks haven’t got too bright a
future if somebody doesn’t help them out. It basically means
that the Irish banks are going to have to put themselves under
ECB tutelage.”

MIXED BLESSING

The facility may prove a mixed blessing for the ECB too.
Although it may be able to return to normal money market
operations, it will risk being dragged deeper into involvement
with the commercial banking sector, at a time when it wants to
step back from crisis fighting and focus on its core role of
fighting inflation.

Some analysts believe the ECB hoped in vain for more active
aid to Irish banks from the European Financial Stability
Facility, the euro zone’s bailout fund. In the end, euro zone
governments, facing their own domestic political pressures, were
unwilling to have the EFSF provide such aid.

“Clearly there’s been a lot of too-ing and fro-ing over who
is going to help here, with the potential that the EFSF was
going to be pulled in,” said Rossi.

“Now it’s back to the ECB, in part because I think this
avoids a de facto acceptance that Europe is bailing out banks.
So it’s back to the ECB to do the job.”

(Additional reporting by Sakari Suoninen; Editing by Andrew
Torchia)

CORRECTED – ECB FOCUS-New liquidity plan to speed exit from crisis steps