Ladies and Gentlemen… Your 530-Billion Euro Free Lunch is Served

Published Wed, Feb 29th, 2012   Martin Denholm

“There’s no such thing as a free lunch,” as the saying goes.

Unless you’re an ailing European bank, that is.

Actually, make it two free lunches.

The debt-ridden institutions gorged themselves at the European Central Bank’s (ECB) buffet table for a second time today, gobbling up another 530 billion euros ($711 billion) worth of cheap loans.

And when I say “cheap,” we’re talking about loans that have a measly 1% interest rate over three years. It follows the bank’s original three-year, 489-billion euro offering in December.

If you’re counting at home, that brings the total amount of free lunch money to 1.01 trillion euros.

Try getting that kind of loan at your bank.

So with many economists stating that European banks already have adequate amounts of liquidity after the first round of funding, what’s the point of this additional cash dump?

Glad you asked…

A 530-Billion Insurance Policy

Let’s spin back to Round 1 in December for a second…

The thinking behind the ECB’s loan program – known as the Long-Term Refinancing Operation (LTRO) – was two-fold:

1. To give hundreds of struggling European banks a cheap and easy way to shore up their cash positions.
2. To stave off what ECB President, Mario Draghi, called a “major credit crunch” in the eurozone. The hope was that banks would invest the money back into the region by buying higher-yielding eurozone bonds, particularly from troubled countries like Spain and Italy.

To a certain extent, it’s worked, too. The markets have risen recently, while borrowing costs in Spain and Italy have fallen.

But lest we forget… this is Europe and the debt problems run deep. So the ECB emptied both barrels today and provided what many economists see as an insurance policy for the region. And if you’re the head of a European bank, why wouldn’t you take advantage of such a generous offer?

In addition, Reuters says Italy needs to sell 45 billion euros worth of bonds in March and April, compared with just 19 billion euros this month. So the new ECB money could prove particularly handy.

But the ECB can’t be Europe’s sugar-daddy forever…

Why the ECB Will Soon Say, “No Soup For You!”

There’s no doubt that the ECB’s measures are extraordinary and unprecedented. The question that the bankers now face is how to take the begging bowl away without triggering further problems.

While some want the Central Bank to offer a third round of loans, the ECB wants to call a halt to the handouts. There are a few reasons for this…

1. No Addiction: It doesn’t want banks to depend too heavily on cheap ECB funding at the expense of interbank activity. Think about it: If you’re a bank and know you’ll be able to keep borrowing from the ECB at 1% for three years, why would you borrow from anyone else at a higher rate?
2. Greater Responsibility: It wants European governments to take more responsibility for the financial security of the eurozone. Namely by employing more fiscally prudent policies and boosting the so-called European Stability Mechanism (ESM) firewall – the eurozone’s safety-net fund. The ESM will be debated at an EU summit over the next couple of days, with the eurozone’s biggest player, Germany, resistant to pouring more money into it.
3. Fear of Inflation: The ECB doesn’t want to trigger inflation by pumping any more cheap money into the European economy. Remember, it’s already crossed the one trillion mark, just from these loan offers alone.

All three reasons are a compelling argument against any future “hand-outs,” although it may be doubtful that European banks will see it this way. My guess is that with this new round of funding, the ECB will be in observation mode while the money works its way into the system and governments try to beef up the ESM.

In any case, if the weaning process ever gets underway, it’s probably not going be pretty.

Best regards,

Martin Denholm