ECB: The euro zone’s aid for addicted banks must not be a free lunch. The European Central Bank looks poised to provide longer-term funding to struggling lenders in periphery states. Doing so is the right move. But the ECB has to ensure its largesse is not abused.
Extended support for troubled banks should not be the ECB’s job. The central bank's main purpose is monetary policy, and its liquidity operations are there to help it control short-term interest rates. But the ECB is providing about 550 billion euros of liquidity to euro zone banks, according to Deutsche Bank estimates. Some lenders in peripheral states, which are cut off from the capital markets, are now almost entirely dependent on the ECB for wholesale funding.
The ECB wants to normalise its liquidity operations. But just turning off the taps would worsen the crisis in peripheral states like Ireland. The country’s six domestic banks have borrowed €85 billion from the ECB, and have also received over 50 billion euros in “Emergency Liquidity Assistance” (ELA) from the Irish central bank. Quitting these in short order would require Irish banks to shrink their balance sheets, further depressing the economy and forcing lenders into a fire sale of bad assets. In that scenario, even the €35 billion set aside for recapitalising Irish banks in November’s bailout might not be enough.
Giving banks certainty on longer-term funding will help them shrink more slowly. Yet the danger is that Irish banks — or Greek and German lenders that might also receive similar support — delay vital restructuring while benefiting from cheap funding. If this went on indefinitely, the ECB's credibility would be severely undermined.
The ECB therefore needs to be tough. In replacing the ELA, it should charge Irish banks a high rate and demand big haircuts on the assets they post as collateral. Then it should require those banks it deems to be over-using its normal liquidity operations to raise funding in the market — or force them to use its new, pricier facility as well.
ECB hawks will still feel the central bank is being too soft. But as long as it wants to avoid triggering another banking crisis, this looks like the least bad option.