Financial Regulatory Forum

SCENARIOS-ECB options to deal with liquidity-addicted banks

By Reuters Staff
September 20, 2010

FRANKFURT, Sept 20 (Reuters) – European Central Bank policymakers are mulling ways to tackle the problem of lenders addicted to central bank liquidity, which is complicating its exit from extraordinary crisis lending measures.

Below are some of the options the ECB could consider to wean banks off the cheap and abundant funding which is pinning market interest rates for maturities of up to four months below the central bank’s benchmark interest rate.

RETURN TO COMPETITIVE TENDERS

The ECB has pushed back a return to ‘normal’ liquidity provision, or auctioning funds to the highest bidder, until at least next year.

If banks remain heavily dependent on the ECB for funding, it will probably have to extend its current policy of offering unlimited funding at shorter-term operations for longer. Austria’s Ewald Nowotny said on Monday markets were not stable enough to allow a return to normal.

Still, hardliners might see a ready-or-not approach as one way of weeding out weaker institutions and forcing consolidation.

LIMIT MAXIMUM BID SIZE

The ECB could use the option laid out in its market operations rulebook of imposing a maximum bid limit on banks participating in liquidity operations in order to prevent “disproportionately large bids”.

The ECB has set bid limits for foreign currency operations and a small number of longer-term euro operations in the past, but never formally for its main weekly operations.

Limits could be imposed universally as a share of bank assets or aimed at addicted banks, for example by setting bid limits if a bank’s outstanding borrowing compared to the reserves it holds at the central bank hits a certain level.

TWEAK COLLATERAL RULES

The ECB has already announced changes to rules on what kind of assets it will accept as collateral for loans next year, imposing higher margins on riskier private debt and on asset-backed securities.

It could tighten the rules further on non-marketable assets or assets such as state-guaranteed bank bonds, on the basis that banks in trouble use lower-quality assets as security.

Non-marketable assets, such as packages of loans, made up 14 percent of collateral submitted in 2009 while uncovered bank bonds made up the largest share of collateral submitted at 28 percent.

PRESSURE GOVERNMENTS, BANKS

Austria’s Ewald Nowotny said last week the problem of bank addiction is primarily one for governments, and the ECB regularly calls for more structural reforms, including restructuring and consolidation of the banking sector.

The ECB has urged banks every month for the last 15 months to take full advantage of government support measures, but its words do not seem to have had much impact so far. (Reporting by Krista Hughes; Editing by Hugh Lawson)

((krista.hughes@reuters.com; +49 69 7565 1313; Reuters Messaging: krista.hughes.reuters.com@reuters.net))

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