ECB Backs Away From Use of ‘Big Bazooka’ to Boost Credit

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The European Central Bank is backing away from any "big bazooka" style intervention to revive lending within the euro zone, delivering a blow to some market hopes of ambitious action.

Small and medium sized businesses that form the backbone of the Spanish and Italian economies have seen their borrowing costs rise to unaffordable levels during the crisis while interest rates charged to their German counterparts are near record lows, reflecting the ECB's rates.

This credit crunch, first revealed by the ECB's own data, has become one of the most visible examples of financial fragmentation dividing the 17-nation euro zone, prompting calls for action.

But the ECB's review of the problem suggests that the blockage in lending is the result of weakened bank balance sheets and would not warrant direct intervention in the SME borrowing process by the central bank.

(Read More: Three Bullets for Draghi as ECB Set to Downgrade Growth)

The ECB has already announced that it is working with the European Investment Bank to devise ways of broadening the access to financing for SMEs by reviving a market for asset backed securities. Senior officials view the initiative as worthwhile but unlikely to be concluded soon or to have a big impact.

"This is not the new bazooka," one person familiar with the matter said. Another said expectations for the policy may have risen too high.

Senior officials regard as much more important the review of bank balance sheets that the ECB plans to oversee before taking over euro zone bank supervisory duties next year. Such an exercise could lead to a more thorough bank balance sheet clean-up, the absence of which may be the biggest obstacle to lending.

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The asset quality review would start in September or October, providing the necessary legislation has been passed by the European parliament. Acting as the so-called single supervisory mechanism, the ECB would oversee an ambitious trawl through 140 of the euro zone's biggest banks' balance sheets.

The review, which will be much greater in scale than a similar exercise at 19 financial institutions by the US Federal Reserve in 2009, will involve deploying foreign supervisors as a "second pair of eyes" to peer review the assessments of national euro zone supervisors, in order to give the process greater credibility.

(Read More: ECB's Draghi Says Euro Zone on Track for 'Very Gradual' Recovery)

Additionally, external advisers will be hired as a "third pair of eyes" on specific issues. It will be followed by stress tests conducted with the European Banking Authority in May or June 2014.

The shift in thinking on the causes for the SME credit crunch puts the ECB closer to the view of Germany's Bundesbank, which has long expressed deep skepticism about the role of any central bank in helping small businesses access financing, for fear of disrupting the market and promoting the mis-allocation of bank lending resources.

Mario Draghi, ECB president, said last month the bank was consulting the EIB and European Commission on initiatives to promote a functioning market for asset-backed securities collateralized by loans to companies. Although it never said it would do so, there were fears, especially in Germany, that the bank might consider buying up bundles of SME loans itself.

(Read More: Asmussen Says ECB Will stick to Expansive Policy)

Meanwhile the German government has finalized details of its own bilateral arrangement with Spain to lend some €1 billion in order to boost credit for SMEs, at German rates of interest.

The deal will allow KfW, the German state-owned development bank, to lend €800m to ICO, its Spanish counterpart, to provide liquidity and capital for SMEs at cheaper rates than they could obtain in the Spanish market.