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ECB poised to get tough on sovereign bond risks

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A top official at the European Central Bank has signaled it will try to force euro zone banks to hold capital against sovereign bonds, in an attempt to stop weak lenders using its cash to hoover up the debts of crisis-hit countries.

In an interview with the Financial Times, Peter Praet, an ECB executive board member, outlined how the central bank could combine its new powers as chief banking regulator with its existing role as currency issuer to toughen up the requirements on sovereign bonds, which have traditionally been classed as risk-free.

(Read more: ECB: Inflation will be below target for 2 years)

The central bank will try to bring about the change in regulatory thinking using its health check of the euro zone's 130 biggest lenders alongside any new offer of cheap long-term liquidity.

Mr Praet said if sovereign bonds were treated "according to the risk that they pose to banks' capital" during the health check, then lenders would be less likely to use central bank liquidity to buy yet more government debt.

The vicious cycle that has seen banks use central bank cash to buy government bonds has been partly blamed for prolonging the eurozone financial crisis.

If the health check were to choke off lending to eurozone households and businesses then the ECB would provide another round of cheap loans, Mr Praet said.

(Read more: Euro zone gets manufacturing boost, France drags)

The ECB is carrying out the health check – which consists of an Asset Quality Review (AQR) alongside stress tests – over the next year before it becomes the bloc's banking supervisor in 2014.

It wants to ensure the process is rigorous without prompting panic in financial markets, although there are fears it could discourage lending to credit-constrained small and medium-sized businesses. Poor access to finance is already holding back the recovery.

Mr Praet, who is responsible for the ECB's economic forecasts, said that while credit conditions remain "quite normal" for this stage in the economic recovery, there was a risk the tests could lead to a further contraction in lending.

More from the Financial Times:

Dual ECB role designed to drive lending recovery
ECB warns growth and inflation to stay low
Rising US yields may force ECB's hand

He said monetary policy would be used "without hesitation" if the ECB's data on money and credit showed banks were continuing to shrink their loan books. The ECB would ensure any liquidity was used to spur lending to the real economy by attaching tougher requirements to banks' holdings of sovereign debt.

This would encourage banks to use any additional liquidity to lend to businesses and households. Previous ECB loans, known as long-term refinancing operations, were predominantly used to buy up more government debt rather than extending corporate borrowing.

"Perhaps paradoxically, a rigorous AQR and stress test helps monetary policy [function]," Mr Praet said.

Mr Praet's comments are the first from a top ECB official to explicitly link the AQR to the governing council's reluctance to have its liquidity used to fund purchases of sovereign bonds.

In the past, the assumption that sovereigns would always honor their debts meant global regulatory standards such as the Basel II accord allowed governments to set their own risk weights for their bonds.

In practice, this meant regulators seldom asked their banks to hold any capital against their holdings of national sovereign debt. Earlier stress tests, conducted in 2011 by the European Banking Authority, placed only limited risk weights on sovereign exposures after the European Council said that it would not let any euro zone sovereign fail.

(Read more: Is the euro zone already running out of good news?)

However, an EBA exercise conducted later that year required banks to hold a capital buffer against government debt.

Mr Praet said: "Should the procyclical impact of the AQR be significant, then monetary policy would be able to act – without hesitation and being reassured that the side effects of a liquidity injection that we have seen for the 2011-2012 [three-year long-term refinancing operations] would be minimized."

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