The ECB’s conducted LTRO – could favourable borrowing conditions clean financial system?

The second European Central Bank’s tender, announced on 28 February 2012, attracted 800 participants. €530 billion will be allotted to banks according to the ECB’s policy to support bank lending and liquidity in the euro area money market. A 1% fixed rate will be applied for the conducted longer term refinancing operations with a maturity of 36 months and the option of early repayment after one year. Favourable borrowing conditions enabled banks to access cheap money; however, will the opportunity be turned to their advantage?

Mario Draghi, a President of the ECB was interviewed with The Wall Street Journal on 22 February 2012. He explained that before the first ECB’s LTRO tender, conducted in December, bank lending survey was exercised. The results revealed a credit tightening with worse circumstances in the southern regions. A 3-year LTRO allotment reached €490 billion in December; however, banks returned €280 billion shorter term credits to the ECB before the LTRO. According to the ECB’s President the net injection was only about €210 billion which most likely will cover the bank’s bonds coming due in the first quarter.

So, could long term refinancing operations relieve market tensions and clean financial system? A lot depends on mutually beneficial solutions. Banks have got an opportunity to borrow from the ECB for a 3-year period at fixed 1% interest rate, so they may repurchase outstanding debts with higher rates and reduce interest expenses. Moreover, in pursuance of higher profitability banks may have intentions to buy sovereign bonds with higher yields. Consequently, banks may expect higher interest incomes as well as increased demand to purchase sovereign bonds could reduce their yields. However, ongoing structural reforms in euro area will take time and high risk of uncertainty still remains.

According to the European Banking Authority’s press release published on 8 December 2011, the EBA recommended to strengthen banks capital positions by building up an exceptional and temporary capital buffer against sovereign debt exposures to reflect market prices as at the end of September. Moreover, banks will have to reach a 9% of the Core Tier 1 capital ratio by the end of June 2012. The reported identified capital shortfall amounted €114.7 billion.

So, will stability targets be entrenched successfully beside profitability goals?