European Central Bank Will Lend $613 Billion to Banks

Seeking to spur bank lending and pull the economy out of recession, the European Central Bank poured 442 billion euros ($613 billion) of one-year funds into money markets on Wednesday, its biggest fund injection ever.

The massive loan, the central bank's first money market operation with a term as long as one year, immediately pushed some bank-to-bank borrowing costs to fresh record lows.

That, the ECB hopes, may give banks enough financial security for them to make more long-term loans to companies and consumers.

A record 1,121 banks rushed to take up the ECB's offer of unlimited funds at a fixed rate of 1 percent, betting they might not see such cheap money again.

Recent data suggests the euro zone economy may start a slow recovery late in 2009, making the ECB unlikely to cut interest rates further.

"We are drowning in money," said a trader at one euro-zone bank. "Maybe now money will finally move into longer-term maturities."

The allotment beat median expectations of 25 traders in a Reuters poll for 300 billion euros, and exceeded the previous record ECB allotment of 349 billion euros in December 2007.

"If financial institutions judge that interest rates are now likely to have troughed in the euro area, this operation represents possibly the final opportunity to obtain 12-month funding at just 1 percent," said analyst Colin Ellis at Daiwa Securities. "This could be the case even if rates edge a little lower, as the ECB has raised the possibility of charging a premium for future longer-term operations."

ECB Executive Board member Lorenzo Bini Smaghi said the loan should reassure banks that they had enough liquidity for the next 12 months, urging them to lend on the funds they borrowed.

"Now they have to pass it on to the real economy, make loans to firms," he said at an economics conference near Rome. "The best way to ensure recovery is maintaining low rates throughout the yield curve, including at the long end. The important thing is low rates at the long end."

Rates Fall

The huge injection of funds — representing about 70 percent of the ECB's outstanding liquidity operations, and 5 percent of euro zone economic output — will not reach banks until Thursday, along with an extra 6 billion euros in three-month funds.

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But news of the injection immediately pushed down shorter-dated money market rates and bond yields.

The three-month London interbank offered rate (Libor) for euros fell 2.6 basis points to 1.185 percent.

The euro fell against the dollar, to about $1.4010 in the early European afternoon from $1.4080 before the results of the operation were announced.

There was talk in the money market that some banks borrowed euros from the ECB in order to exchange it for dollars, because of a surge in U.S. Treasury yields over the past two months, or for other, higher-yielding currencies.

European share prices picked up, partly on hopes that some of the money released by the central bank would eventually find its way into equities investment.

Security For Banks

The ECB warned last week that euro zone banks would probably have to write down another $283 billion on bad loans and securities over the next 18 months. This week's injection of funds should ease the pain of that process.

"It's an extremely generous offer from the ECB which you don't see from other central banks," Barclays Capital economist Julian Callow said. "This is all about giving banks confidence in the term structure of their liabilities to ensure they can keep giving loans."

Tullett Prebon G7 markets economist Lena Komileva said she expected three-month Euribor to drift down towards the 1 percent mark from 1.195 percent at present and also saw downward pressure on overnight borrowing rates.

A few months ago, banks borrowed large sums from the ECB not to lend it out, but simply to protect themselves from the possibility of further shocks to the financial system.

Doing the same with the money obtained in this week's operation, and then parking it with the ECB at an overnight interest rate of 0.25 percent, would lose money for banks and actually inhibit credit flows.

But Komileva said the money market appeared to have regained enough confidence in recent weeks that banks were no longer keen to hoard funds.

"Given the market's recent tendency to hoard less cash at the ECB, a large level of excess liquidity mobilized into the market and lower Euribor rates bode well for investor risk sentiment in private sector capital markets," Komileva said.

Weakness in private sector lending around the euro zone this year has not merely been the result of banks' hesitancy in lending — it has also been caused by a lack of demand from shell-shocked businesses and households.

Analysts said for the funds released by the ECB this week to make a major contribution to economic growth, corporate and consumer confidence will need to improve enough to revive demand for loans.

Copyright 2009 Reuters. Click for restrictions.