Share

Portfolio: ECB Loan a Stopgap Measure for Europe

Print Text Size

Video Transcript: 

Director of Research Kevin Stech explains why the European Central Bank's half a trillion euro loan to European banks will do little to recapitalize Europe's financial sector.

VIDEO TRANSCRIPT:

The ECB today issued about half a trillion euro in three-year loans to banks at an ultra-low 1 percent interest rate in order to address severe and growing strains in the European banking sector. Some of the loans were used to merely refinance other loans, but on the whole, the ECB is providing more than 200 billion euro in new credit to banks. This will go a long way toward shoring up banks' balance sheets, but it doesn't address the conditions that caused the crisis in the first place. There's no question that this move helps the banks, but it only helps temporarily.

The ECB has drastically lowered its standards for the collateral it accepts for these loans, so banks get to offload some very risky assets. The cash they'll receive will generate a superficial improvement for banks — cash is considered the least risky asset to hold. But to move beyond a temporary solution banks have to lend the cash out in order to generate earnings. The cash itself would not earn enough interest to repay the 1 percent rate on the loans.

One of the most talked-about options for generating profits would be buying more European government bonds. European politicians and other advocates of this plan paint it as a win-win scenario. Banks generate earnings by purchasing higher yielding sovereign debt, such as Spain's or Italy's, with the cheap loans and the member countries are thrown a lifeline as they battle their debt crisis.

The idea may seem counterintuitive since European banks are reducing their exposure to higher-yielding government debt, not taking on more, but it's tough to completely dismiss the idea of buying up eurozone government bonds. European governments and their respective banking sectors have historically kept close ties and governments likely will pressure banks to resume buying government bonds. And after the ECB signaled Dec. 9 that it could purchase up to 20 billion euro of sovereign debt per week, there is a huge buyer in the market putting something of a floor under bond prices.

But keep in mind the ECB is not interested in being a steady, predictable buyer of government debt. The central bank is walking a tightrope between preventing sovereign defaults in the eurozone and letting market pressure drive eurozone members toward deep and painful reforms. As negotiations over economic sovereignty unfold, market volatility could severely impact the value of banks' sovereign debt holdings.

Even if banks could be persuaded to jump back into this trade, the best profit they stand to earn on it comes nowhere near the amount of capital that regulators say they need in order to meet minimum standards.

In fact, it's not clear where these earnings might come from. Europe's highly regulated, high wage, low growth environment limits opportunity for domestic investment. Lending in foreign markets can offer attractive returns, but heightens risk rather than lowering it. Banks are left with a range of bad options and may choose instead to do nothing — essentially paying the ECB 1 percent for the ability to hold cash and shore up their balance sheets.

And completely aside from the sovereign debt part of the banking crisis, many banks — notably those in Italy, Austria, Greece — hold questionable assets in Central and Eastern Europe. Many Western banks are still loaded up with toxic asset-backed securities and regional banks like the Spanish Cajas have been used for political and social objectives for years and must now address mounting non-performing loans.

Hundreds of billions of euro in ultra-cheap loans from the ECB will definitely buy Europe some time, but European banks are still badly damaged and in need of a massive recapitalization. The problem is that Europe is completely unequipped to handle this recapitalization.

Get our free weekly Intelligence Reports

Join over 350,000 readers on our free intel reports list.

We will never sell or share your email address or information with anyone.