Record amount of 3-year loans aims to relieve tight credit for borrowers

LONDON - Eurozone banks tapped the European Central Bank for a record amount of three-year cash in an operation that may boost bond and equity markets.

The Frankfurt-based ECB said on Wednesday that it will lend 800 financial institutions 529.5 billion euros ($712.2 billion) for 1,092 days. Economists predicted an allotment of 470 billion euros, according to the median of 28 estimates in a Bloomberg News survey. In the ECB's first three-year operation in December, 523 banks borrowed 489 billion euros.

"The astonishing number this time is the number of banks participating, which signals that a lot more small banks looked for the money and it is likely they will pass it on to the economy," said Laurent Fransolet, head of fixed income strategy at Barclays Capital, the investment banking division of Barclays PLC, in London, who estimated that about 300 billion euros of the total is new lending. "So the impact may be bigger than with the first one."

Bond and equity markets have rallied since the ECB's first three-year loan, suggesting that banks are investing at least some of the money in higher-yielding assets. That's helped ease concern about a credit crunch and won governments time to agree on measures to contain the sovereign debt crisis. The risk is that the banks will become too reliant on ECB money and fail to take the steps needed to strengthen their balance sheets.

The euro fell after the ECB announcement to $1.3432 at 11:47 am in Frankfurt from $1.3471 beforehand. German 10-year bunds extended a decline and Italian and Spanish two-year notes held an advance.

'Stopping the rot'

"There's a big difference between stopping the rot and starting a recovery," said Steve Barrow, head of G10 research at Standard Bank PLC in London. The loans "might have done the first, but they won't do the second", he said.

The economy of the 17 nations sharing the euro is forecast by the European Commission to contract 0.3 percent this year as the debt crisis prompts governments and consumers to cut spending. The ECB's loans are intended to relieve liquidity strains and grease the flow of credit to households and businesses, boosting growth.

A byproduct has been the so-called Sarkozy trade, where yield-hunting banks use some of the cash to buy sovereign bonds - an idea first floated by the French President Nicolas Sarkozy.

Since the first three-year loans were awarded on Dec 21, the yield on Spanish two-year bonds has fallen to 2.24 percent from 3.6 percent, while the Italian equivalent has dropped to 2.14 percent from 5 percent. The Euro Stoxx 50 Index of stocks is up 9 percent this year.

Record low rates

The three-year funds cost the average of the ECB's benchmark interest rate - currently at a record-low 1 percent - over the period of the loans, and banks have the option of repaying them after a year. To encourage take-up, the ECB increased the pool of collateral banks can use to obtain them.

No further three-year operations are scheduled and ECB officials have indicated they would be reluctant to offer a third tranche.

"If number one was a success and number two was a success, that doesn't mean there has to be number three," said Ewald Nowotny, an ECB council member, on Monday.

In the wake of the first operation, the ECB's balance sheet ballooned to a record 2.74 trillion euros. That prompted German council member Jens Weidmann to warn that the central bank mustn't "lose sight of its mandate" to control inflation by taking on "excessive risks".

Bloomberg News