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.

Just a week after warning that euro zone banks will probably have to write off another $280 billion in bad loans and toxic assets over the next 18 months, the European Central Bank has ridden to their rescue by pouring more than double that amount into bank coffers at a bargain-basement rate of just 1 percent.

More than a thousand banks rushed to take up the ECB’s limited-time-only offer of unlimited funds for one year at a fixed interest rate, and will receive a total of 442 billion euros, or $613 billion – the most the ECB has ever lent out in a single operation. 

“We are drowning in money,” a trader at one euro-zone bank said. Goldman Sachs estimated the funds equate to 1,300 euros per man, woman and child in the 16-nation region. 

The central bank is hoping banks will lend the funds on to those men, women and children, as well as other banks and businesses, to bring down the cost of money, encourage spending and shake the region out of a persistent recession.  Money market rates have already fallen to record lows as the ECB has slashed its interest rates, but longer-term liquidity is still scant.

The ECB’s efforts will come to nothing if banks sit on the cash instead of lending it on, or fail to spark consumer demand for credit - so the ECB is betting that spend, spend, spend will light the way out of the downturn.

    European Central Bank President Jean-Claude Trichet could not have been clearer about the short-term path of euro zone borrowing costs after cutting interest rates by another 50 basispoints on Thursday to match the historic low of 2 percent.
    “The next important meeting is in March, not February,” he told the ECB’s monthly news conference, signalling a month’s time-out from the current rate cutting cycle. 
    But Trichet’s new buzzword, that the ECB is keen to avoid a liquidity trap, caused confusion among journalists and economists alike.
    After Trichet cited avoiding a liquidity trap four times in answers to questions about how low rates could go, one reporter finally asked him for a definition, leading to the following exchange at the end of the news conference:
    Journalist: What is your exact definition of a liquidity trap? Is it in the Keynesian sense or how do you define it?
    Trichet: It is Keynesian if you wish, but the problem is that experience has demonstrated that once you were there it was very difficult to get out.”
    Journalist: There, where? You mean zero?
    Trichet: A very, very low interest rate.
    Economists saw his comments as confirmation that rates have further to fall, with most tipping a benchmark ECB rate of 1 percent by September.
    But they were puzzled by Trichet’s definition of a liquidity trap — as opposed to the more usual understanding of a combination of economic recession, low official interest rates, a high propensity to save, and deflation making central bank actions ineffective.
    “Since the ‘trap’ refers to the central bank’s inability to revive the economy, you cannot avoid the trap simply by stopping the rate cuts before you hit zero, if you have not yet had an impact on the economy,” UniCredit economist Marco Annunziata said, noting that the solution was unconventional policy such as direct purchases of assets, U.S. Federal Reserve-style.
    So far, the ECB has not embarked on this path, although Trichet says “non-standard action” is possible.

Just weeks after the European Central Bank tightened its
rules on the assets banks can use as collateral in central bank
lending operations, it’s thinking about broadening them again.

At a summit in Paris on Sunday, euro zone governments
suggested the ECB follow the U.S. Federal Reserve’s lead in
accepting commercial paper, the short-term debt which many
companies use to fund their day-to-day operations.

Europe’s commercial paper market is worth $800 billion, and
the ECB said it would consider changing the rules on
accepting the paper, which must meet the same high standards
applied to long-term corporate and government debt.

The ECB said on Sept. 4 it would toughen these standards to
stop banks taking advantage of its relatively generous rules and
creating artificial instruments to get their hands on central
bank liquidity.

“What we are going to look at is … how we can widen the terms of our rules to have an even broader system of guarantees than we have today,” ECB President Jean-Claude Trichet said on Sunday.

According to the ECB’s statute, it already has the power to
intervene in markets “by buying and selling underlying assets
outright or under repurchase agreements”.

But analysts said the ECB might be unwilling to use this power
because of doubts about who would foot the bill.

Unlike the Fed, which is backed by the U.S. Treasury, the
euro zone central bank has no government chequebook at its
beck and call.

“The problem in Europe is, who would pay?” said Bank of
America economist Gilles Moec. “Who would play the role of the
Treasury when there is no centralised budget authority?”

“Even if legally they can do it, I think that they would be
reluctant to go along the same lines as the Fed.”