ECB Preparing to Close Liquidity Floodgates

The European Central Bank wants its second offer of cheap ultra-long funds next week to be its last, putting the onus back on governments to secure the euro zone's longer-term future.

Bloomberg / Bloomberg via Getty Images A Euro sign sculpture stands in front of the European Central Bank's (ECB) headquarters.

Powerful members of the central bank's 23-man governing council are privately hoping demand at the February 29 auction will fall well short of the 1 trillion euros (837.8 billion pounds) some expect, backing their view that it should be the last.

Central bank sources say they are worried that banks will become too reliant on ECB funds, removing the incentive to restart lending between themselves.

The ECB first offered banks low cost three-year money in December to stave off a freeze in interbank lending that threatened to make the region's debt crisis much worse.

Banks flocked to take advantage of the offer, filling their coffers, and ECB President Mario Draghi said "a major, major credit crunch" had been averted.

Some European officials have been hoping the central bank would carry on supporting the economy with a series of subsequent cheap money auctions, known as LTROs.

But the ECB wants to keep pressure on governments to improve their defense of the euro zone with better economic policies and by bolstering their European Stability Mechanism (ESM) firewall which will come into being by mid-year.

Making hundreds of billions of euros easily available to banks over a three-year period also risks fuelling a credit binge that some central bankers worry could push up inflation.

The ECB funneled banks nearly half a trillion euros in cash at the first operation on December 21. A Reuters poll of over 60 economists showed a mid-range expectation for it to allot another 492 billion euros next week with some expecting up to a trillion to be taken.

Too Generous

The first LTRO, or longer-term refinancing operation, has already eased market pressures.

Borrowing costs for Italy and Spain - at the epicenter of the crisis last year - have fallen, while parts of the interbank lending market have reopened and stock markets have rallied.

Only 15 out of 63 analysts polled by Reuters said banks would bid in the second auction because they needed the cash to shore up their own balance sheets. But with the money costing just one percent, bid they will.

ECB officials accept they have to help the banking sector but they also want to send a message that the unprecedented liquidity provision will end.

Bundesbank chief Jens Weidmann has warned that "too generous" supply of liquidity could create risky incentives for banks, which could in turn store up future inflation risks.

Bank of Finland chief Erkki Liikanen is also worried about ample liquidity provision leading to future problems and has said the ECB must think about how to unwind the extraordinary measures. Other senior policymakers are concerned too.

"Sarkozy Trade"

If banks used the first LTRO to plug their funding needs and fend off a credit crunch, ECB officials hope they could use the second more aggressively to buy higher-yielding bonds, especially from Italy.

Anecdotal evidence suggests banks in Spain used the first LTRO to make most use of this "Sarkozy trade" - a term adopted by markets after the French president suggested governments look to banks that tapped the ECB operation to buy their bonds.

Italy faces a debt issuance hump in the next few months and could do with the second LTRO fuelling demand for its debt. It needs to sell around 45 billion euros of its bonds a month in both March and April versus 19 billion in February.

John Fitzgerald of the Economic and Social Research Institute, a Dublin-based think tank, said further long-term funding from the ECB beyond February may not be necessary.

"Once they have got Spain and Italy over the line in terms of refinancing needs, with much of this refinancing set to be done by March, the need for the LTRO may well disappear," said Fitzgerald, who also sits on the Irish central bank's board.

"The ECB will be able to breath a sigh of relief. It appears this mechanism was enough to turn the markets and that the risk of a collapse in the system is less today."

While ECB officials expect the second LTRO to give a boost to lending as well as bond-buying, they are nonetheless worried about banks becoming dependent on the ECB or heightened liquidity provision leading to irresponsible banking decisions.

Some at the ECB believe banks should now be redoubling their efforts to raise fresh capital, as UniCredit recently did through its rights issue, and fear the ECB's help will create zombie banks reliant on central bank support.

The ECB is also concerned the interbank market is not yet functioning fully. Bankers themselves see this concern.

"If you are flooding the market with cheap refinancing then there comes a point when you are preventing the market from working because nobody is going to borrow from another bank at X percent if they can borrow from the ECB at Y percent," said a senior banker at a leading global bank.

The ECB expects governments to take responsibility for banks that prove too weak to help with extra liquidity and believes states should step in if, in three years when the funding term comes to an end, they are incapable of repaying the credit.

And while governments have made progress dealing with budgets, growth and economic governance, the ECB wants them to bolster the firewall provided by the EFSF and ESM bailout funds and is looking for progress at a March 1-2 meeting of leaders.

This puts the onus squarely on governments, led by euro zone paymaster Germany, to respond to the debt crisis once the ECB has unleashed its second three-year lending operation.

This may come as something of a shock to some banks and officials. One senior EU official said he had expected the ECB would offer banks a third round of long-term funding.

"We expected a third," he said. "They (ECB) have always said they will keep an eye on how the market is evolving. My guess is that they are hedging their bets."