European Banks Rush to Grasp Lifeline? ~ MAKE MONEY BLOG$

Hundreds of euro-zone lenders took out €489.19 billion ($640 billion) in low-interest loans from the European Central Bank on Wednesday

, as the currency area extended a massive financial lifeline to its struggling banking industry.

The unexpectedly heavy demand from 523 banks for the three-year loans highlighted the severity of Europe's financial crisis, while also stirring some hopes that the action could help defuse it, or at least prevent it from getting worse.

Investors didn't seem convinced that the loans would drastically improve banks' prospects. After rallying when the ECB announced plans for the program earlier this month, the Euro Stoxx Bank Index fell 1.5% on Wednesday. In a mildly bearish sign about prospects for the euro debt crisis, yields on Italian and Spanish bonds inched higher.The ECB's loan program—the first in which it has offered three-year loans—appears to be the central bank's main weapon, at least for now, in combating Europe's crisis. The ECB has resisted pressure from politicians and market participants to aggressively buy euro-zone government bonds, arguing such a move is outside its purview. But if the central bank eases fears about the Continent's banks, that would go a long way toward relieving anxiety about many countries' overall financial health.

Through the loans, the ECB is trying to address a crucial weakness in the euro zone's financial system. Nervous institutional investors have essentially stopped lending to banks, fearful of their heavy holdings of government bonds and other assets that appear at growing risk of default.

If the dry spell persists into 2012, it could become a major problem. European banks have more than €700 billion of their own debt maturing next year, including more than €200 billion in the first three months, regulators and analysts say.

ECB officials feared that without intervention, many banks would cut lending to small businesses and households, strangling Europe's weak economy.

"It's much better to have this funding locked in rather than praying the market reopens," said John Raymond, an analyst with CreditSights in London. "I don't think you can say it's a game-changer…but it sort of slows down the vicious circle."

Under the three-year loan offer on Wednesday, banks could borrow as much as they wanted at the low rate as long as they had the necessary collateral. Another batch of three-year loans will be available Feb. 29.

Politicians including French President Nicolas Sarkozy have floated the idea that banks will use the new ECB cash to buy government bonds in financially shaky countries, where lackluster demand has pushed their borrowing costs to unsustainable levels. But bankers and analysts doubt that will happen on a large scale, given the perceived riskiness of such bonds. Banks are free to use the loans for whatever they choose.U.S. officials have urged European leaders to move more aggressively to prevent the crisis from hurting the U.S. economy. The U.S. officials view the ECB loans and other steps by euro-zone leaders as constructive but are pushing for further action to reduce Italy and Spain's borrowing costs.

The 523 banks that borrowed Wednesday range from giants like Italy's Intesa Sanpaolo SpA, one of the few banks to confirm its participation, to tiny lenders. The ECB didn't disclose which banks borrowed under the new program. It's possible that banks from outside the euro zone also pounced on the opportunity to secure cheap ECB financing. Any bank with a legal subsidiary in the euro zone is eligible to borrow from the ECB facility.

"It appears that a very large majority of the large financial institutions" in Europe participated, said Laurence Mutkin, head of European interest-rate strategy at Morgan Stanley.

The ECB's loan program isn't without risks. Some experts and regulators worry banks are becoming more addicted to central bank aid, making it harder for them to eventually stand on their own. At the same time, the program could push banks in countries like Spain and Italy to grow more entangled with their governments—a phenomenon that fueled today's crisis.

While the banks on Wednesday borrowed €489.19 billion, much of that was simply replacing other outstanding ECB loans coming due. Analysts estimated Wednesday's loans injected about €190 billion of new liquidity into the banking system.

Nick Matthews, an economist at the Royal Bank of Scotland, said European banks face about €230 billion of debt maturing in the first quarter of 2012 alone. "This operation is not going to cover all the maturities," he said.

Traditionally, banks satisfied much of their day-to-day financing needs by issuing unsecured bonds to institutional investors around the world. But the market for such debt largely evaporated in July, when Europe's crisis intensified. Regulators and bankers increasingly worry that funding markets could remain shut well into the new year.

The ECB's loans are attractive largely because of their price. The central bank will charge an interest rate that is the average of its benchmark rate over the three-year life of the loans. That rate is currently 1%. It's likely to remain well below what most banks would have to pay to borrow from market sources.

Indeed, the cheap financing is leading some European banks to take steps that further entwine them with their governments.

In Spain Tuesday, the government sold €5.6 billion of bonds in an auction that saw interest rates dive to 1.7% from 5.1% a month earlier. Analysts say the surging demand most likely stemmed from small and midsize Spanish banks buying the bonds in order to use them as collateral for this week's ECB loans.

Such a trade could prove lucrative for the banks, given the gap between the interest rates the Spanish bonds generate and the amount the banks are paying to borrow from the ECB.

But it also means Spanish banks are more vulnerable to their government's financial woes.

In Italy, 14 banks this week issued €38.4 billion of government-guaranteed bonds eligible to serve as collateral with the ECB, according to a document released on Wednesday by Italy's stock exchange. Those banks have been battered amid worries about their excessive holdings of Italian government debt.

"The bank-sovereign nexus still has not been successfully broken and if anything is being reinforced," said Mr. Matthews, the RBS economist.

source: http://online.wsj.com

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