For Europe, Bank Loans, Round 2

 

 

By Jack Ewing

 

FRANKFURT — Central bankers do not like anyone to see them sweat, much less panic. But last November the temperature was clearly rising inside the battleship-gray office tower in downtown Frankfurt that houses the European Central Bank. 

European commercial banks were unable to raise money to lend to customers. Borrowing costs for Spain, Italy and Portugal were threatening to spin out of control, and Greece’s had risen to levels that would make a loan shark blush. Analysts were issuing reports predicting that Greece would leave the euro zone — if the currency union was lucky. The worst case was that the euro would disintegrate. 

“The situation was deteriorating,” recalled one policy maker, who did not want to be named because internal central bank discussions are confidential. “Something had to be done.” 

In the weeks that followed, the central bank’s governing council and its new president, Mario Draghi, succeeded in defusing the tension with a monetary policy tool that they will deploy again this week: unlimited three-year loans to commercial banks at the rock-bottom interest rate of 1 percent. 

The move had a more striking effect than most outsiders expected, and turned Mr. Draghi into something of a hero just weeks after he took office. 

In fact, according to several people with direct knowledge of events, the option had been discussed internally for months. Mr. Draghi threw his weight behind the move, but the perception that he oversaw a radical shift in policy may be misleading. When Mr. Draghi succeeded Jean-Claude Trichet at the beginning of November, an exhaustive analysis of the possible consequences of longer-term loans to banks, conducted by economists and analysts at the European Central Bank and at national central banks, was well under way. 

This week the bank will offer a second installment of the three-year loans. After the first injection of cash helped reopen bank financing markets in Europe and bolster stock and bond markets around the world, there is intense interest in how much money banks will borrow, and what the effect will be. 

A few analysts say borrowing could approach 1 trillion euros, a significant amount, but the majority expect about half that, in line with the first round of three-year loans. One unknown is how much healthy banks will draw on the central bank’s credit in order to make a profit by borrowing money at 1 percent and investing in assets that pay a higher return, like government bonds. The bank will announce the results Wednesday morning. 

If banks borrow significantly more than the 489 billion euros ($647 billion) that they did in December, that may be seen as a sign they are prudently filling their coffers for the years ahead. But some analysts say it could also be seen as an indication that European institutions are more vulnerable than people thought. 

“We would fear that a very high number would not be very positive for the market,” Padhraic Garvey, a debt strategist at ING Bank in Amsterdam, said during a conference call with clients last week. 

The three-year loans are, at first glance, little more than a tweak to existing policy. The central bank has been offering loans to banks on easier terms since the dawn of the financial crisis in spring 2008. After the collapse of Lehman Brothers in September 2008, it removed limits on how much banks could borrow. Provided they could supply collateral, banks could have as much money as they wanted. But the maximum term of the loans was about a year. The bank also cut its benchmark interest rate from 4.25 percent before the collapse of Lehman to 1 percent now. 

No one seems to remember who inside the European central banking world first suggested the idea of tripling the maximum term of loans to three years. By some accounts, the idea originated with someone at the Bank of France, but that is not certain. By October at the latest, and probably earlier, the idea of three-year loans was being debated by staff members of the European Central Bank’s Monetary Policy Committee and its Market Operations Committee. 

Both panels include representatives of the 17 national central banks in the euro zone, as well as the central bank. Meeting sometimes in person and, as the crisis intensified, almost daily by teleconference, members of the panels studied what would happen if the European Central Bank let banks borrow money for such an unprecedented period. 

There were huge risks. Almost by definition, the banks most in need of central bank money would be the weakest institutions, those that were mistrusted by their peers and cut off from interbank money markets. The central bank’s rules say it can lend only to solvent institutions. But differentiating terminally ill banks from ones that are merely struggling is not an exact science. 

At the same time, there were some doubts whether three-year loans would make much difference. Banks could already borrow unlimited amounts for a year, and roll those loans over when they expired. Would three-year loans really be a powerful enough measure to restore market confidence? 

Some economists and political leaders were clamoring for the European Central Bank to throw away its rulebook and buy government bonds wholesale. Within the bank, some more radical solutions were bandied about. The bank had been buying relatively modest amounts of euro area government bonds since May 2010 to try to keep prices in check, but that was no longer having much effect. 

The conservative German Bundesbank and its president, Jens Weidmann, were implacably opposed to emulating the Federal Reserve and its large purchases of securities. The three-year loans offered a compromise. There was a good chance that banks would use the money to buy government bonds, helping to keep borrowing costs for Italy, Spain and other countries under control. 

Meanwhile, market pressure was intensifying. The central bank’s staff members were in constant contact with banks and brokers, both informally and by way of the so-called Money Market Contact Group, made up of representatives of big banks like UniCredit, Deutsche Bank or BNP Paribas. Goldman Sachs and JPMorgan Chase were also represented. 

The picture they painted was bleak. Many banks were unable to sell their own corporate bonds on the open market, one of the main ways they raise money to lend to business and consumers. Yet in early 2012 they would need to roll over hundreds of billions of euros in bonds that were maturing. Some banks would fail if they could not raise new money. Others would have to severely curtail lending, causing a recession and a surge in unemployment. 

Much of the debate took place among staff members below the level of the governing council, which includes the heads of the 17 national central banks. But the staff people were in close touch with top central bankers, and their work helped build a consensus in favor of going ahead with the three-year loans. 

Some in Germany’s Bundesbank, with its deep-seated concern about inflation, argued that the loans should be offered at a higher rate than the benchmark rate, which was lowered to 1 percent on Dec. 8 from 1.5 percent earlier in the year. But that view did not prevail, and when the matter came to the governing council for consideration, also on Dec. 8, the decision in favor was unanimous. 

On Dec. 21, banks submitted their requests for funds to their national central banks, typically by means of a simple electronic form. In a few smaller countries the requests might be submitted by fax. Then the total amount was fed to the market operations room, an open-plan office on a lower floor of the central bank’s building in Frankfurt where employees sat at desks separated by low partitions, scrutinizing multiple data terminals. 

Until the last minute, at least some people within the central bank doubted whether the offer would resonate with banks. But as the data rolled in to the market operations room, it was clear that it had: 523 banks, mostly from troubled countries like Greece, Spain and Italy but also many from France and a few from other countries, borrowed 489 billion euros, due on Jan. 29, 2015. 

It was only then that most outside analysts and investors grasped the significance of the move. Along with changes of government in Italy and Greece and better cooperation by European leaders, the loans lowered money market interest rates and allowed stronger banks to begin selling their bonds again to raise money. The loans ensured that banks would have enough cash to keep operating for three years, and offered markets what they crave most: certainty. 

Bond markets also recovered, with yields on Italian bonds falling from a dangerously high level of more than 7 percent in November to about 5.5 percent on Friday. Apparently some banks are using the cheap money to buy government debt. But even the central bank is not sure how banks are spending the money. Policy makers hope that they will lend it to businesses and consumers to help the European economy. There is a risk, though, that banks will hoard the money, or squander it on risky investments. 

Mr. Draghi maintained that he knew all along what a big deal the three-year loans would be. 

“Maybe I should have called the tender ‘Big Bertha’ when I announced it,” Mr. Draghi said last week in an interview with the Frankfurter Allgemeine Zeitung, a German newspaper. “Then everyone would have listened.” 

NT