Felix Salmon

Why ECB lending won’t solve the euro crisis

By Felix Salmon
December 17, 2011

“By this time next week,” says Simone Foxman, “the euro crisis could be over”; she obviously doesn’t think much of Fitch’s analysis, which concludes that “a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach”.

I’m with Fitch on this one. But it’s worth looking at the bull case for the eurozone, as spelled out by the likes of Foxman and Tyler Cowen. At heart, it’s pretty simple:

  1. The way to solve the euro crisis, at least for the next couple of years, is for the ECB to act as a lender of last resort.
  2. The ECB is, quietly, doing just that — specifically by lending money for as long as three years against a much wider range of collateral than it accepted in the past.
  3. Even though that money is going to banks rather than sovereigns, the banks will borrow as much as they can, at interest rates of about 1%, and invest the proceeds in Spanish and Italian debt yielding more like 6%, in a massive carry trade.
  4. Which means that the ECB is, effectively, printing hundreds of billions of euros and lending it to distressed European sovereigns after all.

This, at least, is how Nicolas Sarkozy has been spinning things:

“Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6-7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.”

But look at the headline of the article that quote appears in: “EU banks slash sovereign holdings”. Here’s a taster:

Europe’s banks have slashed their holdings of sovereign debt issued by the peripheral nations of the eurozone, selling €65bn of it in just nine months…

BNP Paribas cut its holdings by the most, shedding nearly €7bn of the sovereign debt of Greece, Italy, Ireland, Portugal and Spain and leaving it with €28.7bn as at end-September. Deutsche Bank’s €6bn reduction was by far the biggest in percentage terms (66 per cent) and left the bank with just €3.2bn of GIIPS exposure.

My feeling is that, at the margin, banks are going to continue to reduce their holdings of PIIGS debt, rather than decide to follow in the footsteps of MF Global. But don’t take my word for it:

Senior bankers say they will cut further, despite pressure to use newly available, longer-term ECB loans to buy government debt as part of an officially-sanctioned carry trade.

“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”

That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.

Cowen says that “public choice mechanisms will operate so that desperate governments commandeer their banks to make this move, whether the banks ideally would wish to or not” — and normally I’d be inclined to agree with him. Sovereign borrowing always crowds out other forms of bank lending, when a national government decides it really needs the money.

But in this case, it’s not going to happen. Why? For one thing, the main tool that governments can use has already been deployed: if banks load up on sovereign debt, it carries a lower risk weighting under Basel rules and therefore makes their risk-adjusted capital ratios look more attractive. But that’s been the case for decades now, and it can’t be beefed up at all. Meanwhile, bank regulators and investors are looking at a lot of other ratios too, like total leverage. And as we saw with MF Global, they’re hyper-aware of European sovereign exposures these days. Any bank wanting to be considered healthy will stay well away from Spanish and Italian debt.

On top of that, the financing needs of Spain and Italy are much bigger than their respective national banks can fill — especially in the context of those banks trying to deleverage, and seeing their deposit bases move steadily to safer European countries. While national governments are reasonably good at twisting the arms of their own domestic banks and forcing those banks to lend to their sovereigns, they’re much less good at twisting the arms of foreign banks and getting them to do the same thing. Is there any way at all for the Italian government to persuade French banks to lend to it? No.

And more generally, the national debt of big European sovereigns like Italy and Spain is so enormous that it has to be held broadly, in bonded form, by individuals and institutions. Banks alone won’t suffice. Greece is small enough that most of its debt can be held by banks. Italy, not so much.

There’s an argument that it doesn’t really matter whether the banks buy Italian and Spanish debt or not: the main thing that matters is that the ECB is printing money, which is entering the system via the banking system, and which will ultimately find its way into sovereign coffers one way or another, especially since there’s precious little demand for commercial bank loans these days. But I don’t buy it: there’s a virtually infinite number of potential investment opportunities around the world, and there’s no good reason to believe that the ECB’s cash is going to wind up funding Italy’s deficit rather than, say, getting invested in Facebook stock.

If Europe’s banks use ECB cash to deleverage and buy back their own high-yielding debt securities, the investors getting that money are not going to automatically buy sovereign bonds with the proceeds. Especially since those investors don’t care at all about Basel risk weightings.

So much as I’d love Sarko’s dream to come true, I don’t think it’s going to happen. The eurozone’s sovereign crisis is here to stay.

26 comments so far | RSS Comments RSS

Complete the sentence: “It makes economic sense to borrow at 1% and loan at 6% if…”

(A) You expect to be able to continue to borrow at 1% for at least a decade. (Three years of depressed borrowing costs simply isn’t enough.)

(B) You are confident that the bonds will pay out for at least a decade before you are asked to take a haircut.

(C) You don’t care about the long term consequences, as long as you can show a profit for the 4Q.

(D) All of the above.

Posted by TFF | Report as abusive

@Felix : Re : “the ECB is, effectively, printing hundreds of billions of euros”

Can you please elaborate ? I don’t see how ECB is printing money since it *is* requiring collateral, even though “a much wider range of collateral than it accepted in the past.” Maybe you presuppose that some % of this collateral will eventually be defaulted upon, so it will be the ECB (and not the respective bank) that will take the hit ?

Posted by dandraka | Report as abusive

@dandraka, not positive I understand it properly, but I think it goes something like this…

(1) Italian gov’t borrows money, then spends it immediately. (Cash neutral.)

(2) Italian bonds used as collateral with the ECB. (New cash enters system.)

(3) Rinse and repeat.

I’ve seen people argue that “cash creation” occurs when the US Treasury issues securities, since short-term securities serve effectively as cash. But that surely breaks down when a risk of default enters the system? Thus it might be essential to have the ECB accepting the bonds as collateral against ACTUAL cash.

Posted by TFF | Report as abusive

How big are the Spanish “savings” banks that don’t have to respond to investors so much as politicians?

Posted by dWj | Report as abusive

Why doesn’t the ECB lend directly to the governments? If they lend to banks at 1% and the banks lend to the government at 6%, the banks make easy profits (while governments implement austerity programs, yielding an environment where 99% of the people will be really pissed off when 1% get bonuses), and the governments have to spend more to finance their debt?

If the governments end up defaulting, the banks will also. Unless they get bailed out, which means this plan is designed just to enrich the people running the banks.

Why does this scheme sound so familiar?

Posted by KenG_CA | Report as abusive

KenG, if the ECB lends directly to the governments, then how can the governments default? And if the governments get the free money, what motivation do they have to control their deficits?

I don’t know how these loans are structured, but is it possible that the ECB is insisting on sufficient collateral to make large losses unlikely?

And yes, reprocessing/repackaging debt is the primary profit driver in banking.

Posted by TFF | Report as abusive

TFF, the governments can default just as easily if they borrow from the ECB as they would when borrowing from banks – not this year, but in 2 or 3 years or more. Why would they have extra motivation if borrowing from banks?

The post says the ECB is accepting a wider range of collateral, but my guess is the colateral is the government debt. What other collateral could they offer? Mortgage bonds from the US?

I don’t see any difference in how the governments will behave if they borrow directly from the ECB or through re-sellers of the debt (i.e, the banks). The only difference is who profits from those loans.

Posted by KenG_CA | Report as abusive

I understand the ECB cannot lend to governments, only to banks. The Germans resist any move that seeks to change this due to their fears of returning to the era of hyper-inflation in the 1920s/30s that led to Nazism and the destruction of Germany. You can understand they were a little scarred by that.

Posted by FifthDecade | Report as abusive

Rules can be changed, and should be if the situation warrants. If the ECB lends too much to the banks and the banks lend it all to the governments, it won’t be any different than lending directly to the governments.

If excessive government borrowing was alone enough to cause hyperinflation, we would be seeing that in the U.S. now.

Posted by KenG_CA | Report as abusive


This is turning out to be the worst crisis ever

Posted by sandeepY | Report as abusive

KenG, the difference between direct and indirect lending is:
(1) The interest rate. If governments could borrow unlimited funds at a 1% rate, why would they ever stop?

(2) The holder of the bonds in default. Posting bonds as collateral at the ECB is not quite the same thing as selling them to the ECB.

Posted by TFF | Report as abusive

TFF, I didn’t say anything about unlimited funds. I don’t think the ECB is going to loan an unlimited amount of money to the banks, so this isn’t a fair point.

If the ECB lends to banks, and the banks lend to the government, and the government defaults, the banks will default also. Unless the amount they have loaned to the government is such a small percentage of their assets, but that is not likely.

My point is that lending to governments through banks has no benefits, other than to bank executives (o.k., it allows the banks to be sloppier with their other loans, as the margins on their government loans will cover lots of mistakes), while unfairly enriching a small segment of society, and making recovery more expensive for those countries already in dire straits.

Posted by KenG_CA | Report as abusive

KenG, I’m still not convinced that indirect lending has “no benefits”, but would need far more detailed information about the collateral system to prove one way or the other.

Will be interesting to see what happens at the ECB when the loans ultimately default.

Posted by TFF | Report as abusive

The loans, if made to governments, will never default, just like US debt doesn’t default. New loans are made, old loans are rolled over, and people grumble, but the system doesn’t collapse, and people aren’t cast out into the street. If people don’t like it, then they need to come up with an economic system that works for more people, not just a small percentage of them.

Posted by KenG_CA | Report as abusive

You people don’t get it. When the ECT loans money to banks, it is nothing more than a credit on the banks account. Consider it a wire transfer of printed money. The more loans that are made, the more Euros are printed. Does this sound like quantitative easing? It is!

If you were a bank in Italy, you would take the money and buy Italian bonds. Why? They pay a very good rate. Borrow at 1% and lend at 6%: Anybody can make money. I expect a boatload of Italian bonds to be snapped up.

But what if Italy defaults? Rut Rho! Probably not going to happen. Furthermore, the Italian government has probably spoken with the banks to encourage the buying of bonds. It’s the patriotic thing to do.

The ECB bazooka has been found! Very clever!

Posted by WallStreetDude | Report as abusive

@WallStreetDude : I’m no finance/monetary geek but as a matter of principle : when lending, the ECB (or anyone else for that matter) subtracts cash from and adds a security to the balance sheet.

As I understand, you’re saying (and please correct me if I’m wrong) that the ECB is lending without subtracting cash from its balance sheet.

While this is certainly something that any central bank can do, I’m pretty certain that there are a lot of smart people (Felix probably included) that would have noticed.

Posted by dandraka | Report as abusive

The last stand will be Spain. If one applies a 60% loss ratio on property developper loans (Ireland @ 80%) on Spanish banks loan book (circa 350Bn euro), then that points to €200bn loss in spanish banking system. If Spanish banks are re-capitalised to the tune of €200Bn by the Spanish government, then that brings Spanish net debt/gdp to 100% (if autonomous region debt is added to central govt debt). That leaves you with a highly indebted Spain that is dependent on external creditors (unlike the Italians – who are alot wealthier than the Spanish BTW) and structurally fubar i.e. few export champions, unemployment at 20%, further austerity, no devaluation. Spain is and always has been the elephant in the room. phoney accounting has delayed their property bust by 3 years on paper. who will fund Spain?…Ireland/Greece/Portugal haircuts are already fact…when the market really focuses on Spain, that will be the litmus test for Euro.

Posted by georgehanson | Report as abusive


The ECB is no different than any other bank with respect to the creation and destruction of money. Think about it; where does money come from? The genesis of money is always a loan from the central bank to another bank. The central bank does not perform double entry bookeeping. When it makes a loan of cash, it literally invents the money out of thin air. When the loan is paid off, poof! the money is gone into thin air.

The concept of inventing money out of thin air and destroying it with a wave of a wand scares most folks. But that is what happens.

Posted by WallStreetDude | Report as abusive

Of course the ECB is acting now as a lender of last resort albeit limited by law, that only permits liquidity easing to banks, not states.
The only doubt I have now pertains to the political domain: why commentators sistematically devalue political statements and movements that clearly indicate a firm commitment of european partners in maintaining the euro as the single currency of the ENTIRE eurozone ?
We all know that a sudden conversion to national currencies or even new regional currencies would be a disaster to all Europe and perhaps to the World. So, it´s unthinkable that the most wealthy region in the world could embark in such a self-destructive path. That´s plain common sense.

Posted by southmed | Report as abusive

ECB lending will fail because no one has a plan for growth that is required for repayment. Banknotes cannot have sex with other banknotes to create new banknotes whether the banknotes are in cash or electronic pulses in cyberspace. The huge hoards of money will not remove the finance charges that will continue until the money is depleted. Loans to small businesses create the most new entrepreneurs, ideas, jobs, workers, paychecks, products, customers, profits, and taxes. Profits expand companies, repay banks, and pay taxes. Taxes let governments pay interest, pay debts, and finance programs. Small business plans for businesses, banks, and governments would focus thoughts on tasks needed for success and would reassure creditors that debtors know what they are doing and will repay the loans. Unfortunately, leaders of governments and big banks have become arrogant and lazy. They prefer news interviews to effective work.

Posted by alanchristopher | Report as abusive

A global ponzi scheme and a shell game! The end is only delayed in this latest delay. The end result will be more debt and a bigger disaster in the end!

Posted by sbenard | Report as abusive


The cognitive dissonance you sense is due to the non-synchrony of words vs. action by Germany. Angela Merkel has said repeatedly that she want the Euro. No buts about it. But her actions in preventing the ECB from unleashing the bazooka says otherwise. The fire of fear in the EU financial markets will remain until John Wayne show up with his bazooka.

The other more deeply rooted factor is that a Euro in Germany is not the same as a Euro in Greece. In Germany, the Euro will buy the output of very industrious and smart people. In Greece, one Euro will buy the output of a Greek who rather be drinking ouzo rather than working. In reality the former is worth more. The market has a hard time figuring this out.

The Germans know this of course. But they benefit because the Euro is weaker due to the less industrious countries in the Mediterranean. A weaker Euro to Germany is good for exports. But the Germans only like this deal if they don’t have to spend too much to bail out the lesser countries.

Posted by WallStreetDude | Report as abusive


Europe will delever by the German Plan: austerity. You can pay off the notes if you eat pork and beans. This is the German way. They have the mental resolve to suck it up and get it done. They took on the burden of unifying East Germany at a cost of billions of Euros.

I am not so sure of the Mediterranean countries. Austerity can be a real drag on their lifestyle. Greece may balk at Teutonic discipline and bail out of the Euro. How easy is it to default on all the debt and then relax with a glass of ouzo?

Posted by WallStreetDude | Report as abusive

I am probably too stupid to understand all these intelligent financial manouevering……but it seems to me nothing significant has changed with the fundamentals.

There are more funds in the system…but where are these funds going to be applied? Banks loan to Sovereigns…sovereigns are still …
1) overspending (not efficiently)
2) consumption vs production is still an issue
3) funds to Govt, Govt issues bonds, bonds as collateral to increase private lending, collaterals become toxic assets……
4) prudent and efficient economies have to bail out reckless and inefficient ones, perpetuating the problems.

Tell me again why is the market so happy today?? Because some finance guru and their associates will be making their Q4 numbers, and FY bonuses??!!

Working the numbers has become such an obsession, that we forget that the markets are meant to facilitate the mainstream economies……and “the street” is not the be all and end all of the game on both sides of the “pond”.

Posted by Keltmpoh | Report as abusive

The plan doesn’t pass the common sense test. It asks extremely risk-averse commercial banks to assume a “hedge fund” / high risk carry trade in an environment where they’re not deploying cash to anyone. Sure, sovereigns could force feed their own banks to the trade, but that’s a small percentage of the total sovereign financing need. When a commercial bank does take the trade, its stock is quickly hammered in the market, and shareholders lose, perhaps significantly. Shareholders aren’t public philanthropists. Won’t work.

Posted by sarkozyrocks | Report as abusive


There are many who view the wonton printing of money as heresy. They call for the gold standard which by its very nature limits the money supply. There is a major fault with this argument: There is not enough gold to go around.

Think about what a central bank does. It creates (prints) money that facilitates transactions. As the economy grows, more money is needed. What is a sovereign bank to do? Tax the populace to get money to buy more gold so they can print more money? Not very efficient. And what is other countries have a gold standard? The accommodate everyone, the price of gold will go through the roof. This causes banks to impose more taxes to get the money to buy the gold…..

You get the idea. The gold standard is not the answer.

Posted by WallStreetDude | Report as abusive

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