ECB On Right Track

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Stressful situations requires boldness, cold mind and a warm heart. During stress a leader must be able to take risks and point out the direction despite not having time to perform complete analysis and he or she even has to take unexplored routes. This is what the ECB (European Central Bank) did on the 21 December when they granted a 3-year 490-billion financing to the banks, at the unbeatable rate of 1%. This action is proof of bold leadership and may not work without hiccups but with the information we have today it seems to be a clever thing to do. It will certainly counter some of the liquidity quota problems in Basel 3.

Mario Draghi

This is a quote from a Financial Times interview with Mario Draghi, new head of the ECB: "The objective is to ease the funding pressures that banks are experiencing. They will then decide what the best use of these funds is. One aspiration is to have them financing the real economy, especially small and medium sized enterprises (SMEs). What we are observing is that small and medium sized banks are the ones having the biggest funding difficulties, and they are generally the ones who provide most of the financing for the SMEs. And SMEs account for about 70 per cent of employment in the euro area’s corporate sector". 

I have had some discussions with people in the industry and there are two main scenarios as to how effective this program will be.

Optimistic Scenario
Since the European leadership previously has done several blunders unnecessarily escalating the debt crisis to unforeseen levels, something had to be done. Too many investors are leaving the European debt markets, they have especially stopped investing in sovereign and bank debt. A similar operation is planned on February 29, 2012. The credit institutions may use this new cheap resource to finance governments, corporates (remember the emphasis on the SME, often being the weak links in the supply chains) or households, or merely to anticipate the refinancing of most of the banks own 600-billion debts maturing in 2012. In both cases, this operation will provide them with a few dozens of billions of Euros of additional profits over the next 3 years, some easy money to facilitate their recapitalization. 

Pessimistic Scenario

Will the Transmission Effect
work this time?

Draghi does not say that this money will go to the SMEs or weak, but important lenders, he says that ideally it should go to them. However the banks can do whatever they want with this money. Many people working in the banking sector or in the capital markets don't believe banks will use these funds to finance the economy instead they will keep them to refinance their own debt maturing next year and deposit them with the central banks and finance old lending only. That is actually what they did with the hundreds of billions injected in 2008-2009 blaming a sharp fall in credit demand and surprisingly got many central banks believing them. 


Recommendations
This huge bank financing scheme could have been combined with a method to limit how much a bank can deposit with the central banks to ensure the so called Transmission Effect remains effective. 


The ECB might also consider introducing certain quotas of collateral originators, e.g. x % for SME, the banks have to submit to receive the funding. This could be expected to ensure the ambition to steer the funding to the ailing sectors.