ECB: Banks Need to Wean Themselves of Liquidity Support

A very interesting pair of articles tonight comment on a statement today by ECB governing board member and President of the Dutch Central Bank Nout Wellink to the effect that banks were overly dependent on the ECB’s liquidity facilities and needed to start fending more for themselves. Ed Harrison at Credit Writedowns translated an article in Financieele Dagblad, a Dutch financial newspaper (we’ve also chatted about it by e-mail), and the Telegraph has weighed in as well.

Here are opening paragraphs from the Dutch article:

The European Central Bank cannot continue forever to provide liquidity to banks with money market problems. So says Nout Wellink, President of the Bank of the Netherlands and board member of the ECB, in an interview with this newspaper.

“If we see that banks have become very dependent on central banks, then we must encourage them to tap other sources of funding.” This means that shareholders, in extreme cases, must come up with money.

Ever since the credit crisis erupted a year ago, central banks have pumped tens of billions into the market to avoid a systemic crisis. “There has been an adequate response,” Wellink said. “But there must be a limit to how long you can do this. There comes a point when the market takes over. “

Now one might think the substance of Wellink’s comments to be perfectly reasonable (after all, these facilities were never intended to be permanent) but his remarks were particularly pointed, and seemed oddly timed, given the worsening economic outlook, and thereby hangs a tale.

By way of background, Spanish banks, who hold a lot of lousy mortgage paper, have been very heavy users of the support mechanisms, so much so that that some have deemed it to be a covert bailout of the Spanish banking system. And that is creating tensions, as the Telegraph notes:

While he [Wellnik] did not name the chief culprits, there are growing concerns about the scale of ECB borrowing by small Spanish lenders and ‘cajas’ with heavy exposed to the country’s property crash. Dutch banks have also been hungry clients at the ECB window.

One ECB source told The Daily Telegraph that over-reliance on the ECB funds has become an increasingly bitter issue at the bank because the policy amounts to a covert bail-out of lenders in southern Europe.

“Nobody dares pinpoint the country involved because as soon as we do it will cause a market reaction and lead to a meltdown for the banks,” said the source.

This “soft bail-out” is largely underwritten by German and North European taxpayers, though it is occurring in a surreptitious way. It has become a neuralgic issue for the increasingly tense politics of EMU.

The latest data from the Bank of Spain shows that the country’s banks have increased their ECB borrowing to a record €49.6bn (£39bn). A number have been issuing mortgage securities for the sole purpose of drawing funds from Frankfurt.

Note that the Telegraph presented Wellnik’s views as an ECB statement, but I wonder. Wellnik could have been speaking in his capacity as a Dutch central banker (after all, Netherlands banks are part of the problem) or floating a trial balloon. And there is yet another possible layer of interpretation: this remark may have been more to placate the public than a serious statement of intent.

Regardless, it probably makes sense to take them at face value. Why? The Telegraph argues that ECB is pushing the envelope:

The ECB has accepted a very wide range of mortgage collateral from the start of the credit crunch. This is a key reason why the eurozone has so far avoided a major crisis along the lines of Bear Stearns or Northern Rock.

While this policy buys time, it leaves the ECB holding large amounts of questionable debt and may be storing up problems for later.

The practice is also skirts legality and risks setting off a political storm. The Maastricht treaty prohibits long-term taxpayer support of this kind for the EMU banking system.

Few officials thought this problem would arise. It was widely presumed that the capital markets would recover quickly, allowing distressed lenders to return to normal sources of funding. Instead, the credit crunch has worsened in Europe.

Not surprisingly, banks are gaming the system:

Not to miss out, Nationwide recently announced that it was setting up operations in Ireland, partly in order to be able to take advantage of ECB liquidity if necessary. Any bank can tap ECB funds if they have a registered branch in the eurozone, although collateral must be denominated in euros.

Jean-Pierre Roth, head of the Swiss National Bank, complained this week that lenders were getting into the habit of shopping for funds from those authorities that offer the best terms. The practice is playing havoc monetary policy.

“What we should avoid is some kind of arbitrage by banks, which say they are going to go to central bank X, instead of central bank Y, because conditions are more attractive,” he said.

Politics aside, the ECB may be recognizing well ahead of the Fed that there are limits to what it can accomplish, And in triaging the European financial system, smaller Spanish banks probably do not make the cut. The ECB is likely to become more stringent in an effort to keep some powder dry in the event that conditions deteriorate further. As Ed Harrison noted:

Wellink suggests that the ECB use Walter Bagehot’s model for a lender of last resort: lending freely at a penalty rate but limiting the overall liquidity to the banking sector as a whole. If Wellink’s views are shared by other ECB governing council members, we may need to get ready for some serious liquidity strains for weaker banks going forward. The Bank of Canada has already stepped away from its role in providing liquidity. Will the ECB be next? And what will this mean if a European bank runs into trouble?

Some observers have said that the ECB is not set up to undertake a Bear-style rescue. Thus, any recapitalization or takeover would presumably fall to the treasury of the country where the troubled institution is headquartered. But given the co-ordination issues during the Northern Rock failure among regulators located in the same country (the FSA, the Treasury, and the Bank of England), there’s even more reason to worry about a mishap with the EU and national banking authorities trying to contend with an emergency.