A second wave of cheap European Central Bank money is about to swamp the euro zone's ailing banks, setting the stage for a share price rally like the one that revived the markets late last year.
Economists and analysts predict that the ECB will hose out no less than €400-billion ($530-billion) – and as much as €1-trillion – in 1-per-cent loans to struggling banks in Italy, Spain and other countries in the debt-stricken regions of the euro zone.
Since the first injection on Dec. 22 share prices in the euro zone have climbed about 13 per cent. The ECB is scheduled to open the loan spigot again on Feb. 29.
But the ECB, wary of moral hazard, has hinted strongly that the second "long-term refinancing operation," or LTRO, will probably be the last. The central banks of the few remaining triple-A rated countries – Germany, the Netherlands, Finland and Luxembourg – oppose a third instalment of the ECB's loan gusher. Their argument is that the loans are, in effect, a form of bailout that acts as disincentive for the banks to clean up their own acts.
Euro zone banks sucked up €489-billion in cheap loans in the first LRTO, which was implemented by then-new ECB president Mario Draghi, the former governor of the central bank of Italy. It was the first time that ECB offered the banks the security of three-year loans.
At the time, the interbank lending market had dried up and Mr. Draghi feared that a Lehman Bros.-like bank collapse, coming on top of the Greek-inspired debt crisis, would potentially rip the European banking and payments system apart. After the banks loaded up in December with ECB loans, he said a "major, major credit crunch" had been avoided.
While estimates of the new LRTO's size range as high as €1-trillion, most economists expect the tender to be similar in size as December's version, whose biggest allotments went to Italian and Spanish banks. In a conference call on Wednesday, economists and strategists at ING Financial Markets predicted the banks would take no more than €600-billion in fresh ECB liquidity, though they did not rule out a bigger number.
"A high number could be viewed as the banks being prudent," said Padhraic Garvey, ING's head of rates strategy in Amsterdam, "or a point of vulnerability."
The ultra-cheap ECB loans were designed to add liquidity to the banks at a time of financial stress and give them the reserves to cover the hundreds of billions of euros of bank debt maturities between now and 2014. Another purpose was to allow the banks to profit from so-called carry trades – borrowing ECB money at very low rates and lending it out a higher rates.
French President Nicolas Sarkozy urged banks to use the first LTRO loans to buy the bonds of Italy, Spain and other countries at the centre of the debt crisis. While it is hard to tell how much of the loans were used to buy sovereign debt, government funding costs in the stricken countries, notably Italy, have fallen considerably since then, taking the edge off the debt crisis.
The first LTRO failed in the sense that it did not encourage loan growth, keeping many small- and medium-sized businesses starved of credit, economists said. The banks simply put much of the loans back on deposit at the ECB.
The loans also may have taken pressure off the banks to fix themselves.
In a note published on Wednesday, Deutsche Bank 's economists said that "bank restructuring is undermined by an overly generous provision of funds from the central bank.
"Instead of going through painful restructuring, banks may use the cheap central bank money to fund large-scale purchase of government bonds in the hope to use the profits from the carry trade to strengthen their balance sheets."
Because of the moral hazard, the ECB is unlikely to announce a third LTRO, economists said, though a renewed credit crunch could convince the banks to shovel out more loans.
In spite of its drawbacks, there is no doubt the first LTRO helped to stabilize the banks and boost market confidence. The second is expected to do the same. "We can almost certainly expect further equity market strength," ING economist Rob Carnell said.