ECB happy with liquidity flood, but is it in greater good?

July 2, 2009

Central bankers have not had much reason to be happy over the last two years, as the financial crisis has lurched from bad to worse.

But the European Central Bank at least is now finding comfort in the fruits of its injection of close to half a trillion euros in 12-month funds last week, which has pushed money market interest rates to new record lows

“We are very happy, we see clearly that we decreased the risk premia,” ECB President Jean-Claude Trichet said on Thursday, after the ECB kept its benchmark rate on hold at 1 percent.

Still, the ECB’s generosity in filling bank coffers with cheap cash could paradoxically help financial institutions defer the day of reckoning when they will have to write down bad loans and toxic assets on their books, and adjust their balance sheets. Flush with ECB cash, banks could be encouraged to think they can hang on to past investment mistakes, rather than writing them down now. 

The Swiss-based Bank for International Settlements, a forum for the world’s central banks, says this painful process is a prerequisite for financial and economic recovery, and the International Monetary Fund  says the euro zone is lagging the United States in writedowns.

Maybe the ECB is not helping.

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