27 March 2012

FT Analysis: European finance - The leaning tower of perils

Critics are increasingly concerned that by helping to save banks and governments now, the ECB may unwittingly be sowing the seeds for the next escalation of the crisis. That would shatter the calm in global markets of the past few months and cause renewed soul-searching about the continent’s single-currency project.

Concerns over the LTRO are several, ranging from the question of banks becoming dependent on artificially cheap funding to fears about the structure of their balance sheets. But one of the main charges is that the sheer cheapness of the funds has prompted banks to go on another credit-fuelled binge, similar to what preceded the global financial crisis but this time snapping up the debt of their own governments.

Their bond buying has brought bond yields down for the likes of Italy and Spain but it has also caused the fates of banks and countries to become even more inextricably linked. “There is a risk it’s like tying two drowning people together in the hope they will float”, says Benedict James of Linklaters, the law firm.

Policy-makers are not oblivious to the dangers. ECB officials insist the LTRO was necessary to relieve market tensions, especially about the possibility that one or more eurozone banks could collapse because of funding difficulties. But they also acknowledge that there are risks to the scheme. Jens Weidmann, the president of Germany’s Bundesbank, has gone further, warning in a speech in February that “too generous a provision of liquidity will open up business possibilities for banks that could lead to greater risks for the banks” and thus jeopardise financial and price stability. The German central bank did not try to block the LTRO, unlike its resistance to other recent ECB policies, but it would have preferred less-favourable terms to have been set.

A second big problem that many see is that the LTRO lessens the pressure on both banks and sovereign borrowers to reform. In essence, the ECB loans have bought three years for banks to reform themselves and for the southern countries in Europe to rekindle economic growth.

Within the ECB’s 23-strong governing council there is also widespread concern that by relieving financial market tension and helping subdue bond yields in what some have dubbed “backdoor quantitative easing”, pressure on governments for fiscal and structural reforms has lessened. Some in Frankfurt have already been alarmed by Spain’s defiance over its fiscal targets this year after dramatically breaching them in 2011.

LTRO critics reject suggestions they are being churlish, given that markets have undergone a remarkable stabilisation this year compared with the dark days at the end of 2011. Concerns that the next few months could have been highly tricky for banks in terms of funding have dissipated, they agree, as has the “tail risk” – marketspeak for an event that could disrupt markets’ central muddling-along scenario – of a lender going bust.

But many remain worried about just what the LTRO will end up achieving. Banks remain under pressure to shrink their balance sheets, a process known as deleveraging, even if the LTRO has eased the strain somewhat. As UBS’s Mr Ryan asks: “What is LTRO? Is it a useful tool to manage deleveraging, quantitative easing via the back door, or a convenient way to avoid restructuring?”

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