ECB ‘saves’ banks as economies sink

by Edward Chancellor

Financial Times
February 5, 2012

Stock markets generally like to party in January. Last month’s celebration was particularly ebullient. Having been in freefall for much of last year, Europe’s stock markets enjoyed their best January since 1998. The master of ceremonies was Mario Draghi, the recently installed head of the European Central Bank. The ECB’s decision in early December to provide almost limitless funds to the European banking system brought 2011’s financial dance macabre to an abrupt halt. While liquidity concerns have abated, Europe’s solvency crisis is far from over.

Last year, a nasty feedback loop opened up as rising sovereign default risk in Italy and Spain fuelled concerns about the asset quality of European banks. Depositors started to become restive. Falling stock prices and rising credit spreads caused difficulties. The interbank loan market froze over. As the panic endured, Europe’s banks were forced to shrink their assets.

This was a very dangerous state of affairs which, had it continued unchecked, might well have led to major bank failures. In early December, however, the ECB announced it would extend the length of its funding to European banks to three years. Banks immediately applied for nearly €500bn from the Long-Term Refinancing Operation (LTRO). A second LTRO, which many expect to be twice as large, will be launched by the ECB at the end of this month.

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