ECB Tender Hints At Weak Spots In Improving Market

By Geoffrey T. Smith

Of DOW JONES NEWSWIRES

FRANKFURT (Dow Jones)--The European Central Bank on Wednesday wrapped up its anti-crisis program of extraordinarily long-term lending to banks with a funding operation that is likely to keep short-term euro interest rates ultra-low at least for another six months.

Analysts said the results of the tender suggested that much of the banking system can now live without the ECB's life-support mechanism, but that a small number of banks are still highly dependent on it, and the European banking system still has plenty of weak points that could cause trouble in the future.

The ECB said it injected EUR96.937 billion at a 12-month lending operation, the last of three that it announced in the spring in order to guarantee that banks in the 16-country currency bloc have access to longer-term funding to weather the credit crisis.

Market conditions have eased substantially since then. The interest rates at which solid banks lend to each other for short periods--even without the safety of collateral--are now below the ECB's reference rate of 1%.

Analysts said that the money allotted Wednesday--which will increase the total amount of ECB money in the market by around 14%--will keep the Euro Overnight Index Average, or EONIA, which is the key rate for interbank overnight money, around its recent level of 0.30%-0.35%. It was little changed after the operation, as was the euro, which ticked only fractionally higher against the dollar Wednesday.

Actual overnight rates have barely moved from this level since the ECB's first 12-month tender--a mammoth EUR442.24 billion in June--created a structural surplus of money in the market and reduced the cost of borrowing accordingly.

Silvio Perruzzo, an economist with Royal Bank of Scotland in London, said he doesn't expect EONIA to move until the funds from this first 12-month tender mature next June, taking away much of the excess liquidity currently in circulation.

As in the previous two 12-month tenders, the ECB gave banks all the money they asked for. However, in contrast to those tenders, it said the effective interest rate wouldn't be a fixed 1%, but rather would be tied to the average rate at the main one-week refinancing operations over the next year.

This move was generally interpreted as an effort to stop banks from indulging in risk-free carry trades--using money borrowed at low, fixed rates to finance bets on government bonds or foreign-currency deposits offering higher rates. The indexation means that banks won't know the final cost of the funds until a year from now.

Banks have deployed the cheap ECB billions mainly in two ways this year: either hoarding them to insure themselves against possible defaults by other banks, or throwing them at perceived low-risk instruments, particularly government bonds. The latter has generated handsome paper profits for the banks but raised concerns about a possible bubble in those markets.

"Indexation has halted the speculative demand," said Lena Komileva, an analyst with Tullet Prebon in London. She estimated that the market had needed only EUR70 billion from the bank, and that the remaining EUR27 billion was "precautionary."

The number of banks bidding, at 224, was down by more than 60% from 589 at the previous 12-month operation in September, indicating that many more banks now have access to the market instead of relying on the ECB, Komileva said.

However, the banks that remain dependent on the ECB appear to be even more dependent than they were three months ago, the average bid rising from EUR128 million to EUR433 million.

"Those banks which went to the ECB this time are clearly those which are having difficulty funding themselves in the market," RBS's Perruzzo said.

Tullet Prebon's Komileva said the tender suggests an increasing polarization in the euro-zone money market, between those banks that are successfully overcoming the crisis and those that aren't. Greek and Austrian banks in particular have been in the spotlight in the last week amid a fresh wave of fears over their exposure, respectively, to domestic fiscal problems and continuing pressures from bad loans in central and eastern Europe.

"Structurally, the tender shows more normal conditions in the core [European market], but the periphery is still struggling," Komileva said.

The ECB, as ever, declined to comment on which banks participated in the tender. Last month, the Greek central bank had urged Greek commercial banks to show restraint at the tender, rather than increase their dependence on ECB funding.

The ECB plans one final six-month tender in March to smooth its exit from longer-term refinancing operations. After March, none of its operations will be longer than the three-month tenders the ECB had offered since its inception in 1999. The central bank plans to end most of its other non-standard policy measures over the course of 2010, as the banking sector completes its return to health after the financial crisis.