European Central Bank loans $639 billion to banks. Will it help?

European Central Bank loans are intended to keep banks lending and avoid a credit crunch. But the head of the European Central Bank resists providing similar help to indebted nations.

Virginia Mayo/AP
European Central Bank President Mario Draghi speaks during a meeting of the Economic and Financial Committee at the European Parliament in Brussels on Monday. The European Central Bank loans were the biggest credit infusion in the 13-year history of the euro.

The European Central Bank flipped its credit tap wide open Wednesday to help Europe's troubled banking system, allowing hundreds of nervous banks to take out a record €489 billion ($639 billion) in loans.

The European Central Bank loans were the ECB's largest infusion of credit into the banking system in the 13-year history of the shared euro currency. It aimed to keep the Europe's debt crisis from choking off credit to businesses — since a credit crunch could cause a continent-wide recession that would make the debt loads hanging over the 17 nations that use the euro even harder to pay.

Many European banks are also having trouble borrowing normally from other banks — everyone is afraid they won't get paid back because the banks they are lending to may have large amounts of risky European government bonds.

The ECB loans to 523 banks surpassed the €442 billion ($578 billion) in one-year loans from June 2009, when the global financial system was reeling from the collapse of the U.S. investment bank Lehman Brothers.

Wednesday's credit offering, dubbed a longer-term refinancing operation, let banks load up with as much cheap liquidity, or ready money, as they think they need and not have to worry about paying it back until early 2015. It was the first of two three-year credit offerings that the ECB has planned.

The ECB hopes banks can use the credits to help pay off some €230 billion ($300 billion) in bank bonds that are maturing in the first months of 2012. Otherwise, banks would have had to find that money by cutting back on loans to business.

Many economists think that the eurozone is already heading toward at least a mild recession — figures Wednesday showed that Italy, the eurozone's third-largest economy, contracted 0.2 percent in the third quarter.

The deeper the economic slowdown is in the eurozone, the more tax revenues may suffer — and the harder it will be for Europe's indebted governments to handle their debt loads.

Although the ECB credits can help banks and the economy get through the crisis, they don't attack the cause of Europe's problems — too-large amounts of government debt — or convince markets that European governments can get a grip on their public finances. And it doesn't remove one of the main reasons why banks remain wary of lending to each other — their thin levels of capital reserves against potential losses.

All that means despite the massive influx of cash, Europe's debt crisis will still be churning in the New Year.

Markets initially rose modestly on the outsized amount of credit support, which was far higher than the €300 billion ($392 billion) expected, but the advance soon faded as the loans highlighted the problems facing Europe's banks. The Stoxx 50 of leading European shares was down 0.5 percent while the euro was trading 0.6 percent lower at $1.3038.

"The good news is, the ECB's efforts to increase liquidity are working," said Jennifer Lee, an analyst at BMO Capital Markets. "The bad news is, high demand for the loans creates worries that banks are urgently in need of funds to boost liquidity."

Italy and Spain have been at the center of investor concerns in recent months as their borrowing costs have risen amid concerns over their debts. Both are considered too big to bail out with the current eurozone bailout funds, which have some €500 billion ($654 billion) in financing.

A default on debt payments by either could ignite a new financial crisis and send the global economy into a slump.

Some of that European rescue money is already committed to bailouts of smaller Greece, Ireland and Portugal, which needed outside financial help after default fears drove their borrowing costs to unsustainable levels.

Italy alone has some €1.9 trillion ($2.5 trillion) in outstanding debt.

In making the loans, the ECB was playing its role of supplier of liquidity to banks, a typical job for central banks.

ECB president Mario Draghi has stressed the central bank's role in supporting the banking system but has balked at suggestions it should be offering the same level of support for indebted governments themselves by buying up their risky bonds. Draghi says governments must be the ones to reduce their spending and deficits and should not depend on a central bank bailout.

There was some speculation that the loans could help governments, since banks could borrow money cheap from the ECB and use the money to buy higher-yielding European government bonds.

But many analysts think it was unlikely that banks would increase their exposure to government bonds, given ongoing fears of a possible default among troubled eurozone nations. Many banks have struggled to cut their holdings of debt from governments in financial trouble.

"We still believe it is difficult to reconcile a government desire for banks to continue buying debt with the need for banks to reduce risk exposure associated with government debt," said Chris Walker, an analyst at UBS.

The 37-month term of the loans permits the banks to stock up on money for a much longer period and reduces stress on their finances. Draghi has said the extra-long credit period will allow banks to lend for longer periods and not cut credit to businesses.

Alongside efforts to shore up banks, the European Central Bank has also been cutting interest rates to support the ailing eurozone economy. It has reduced its main refinancing rate from 1.5 percent to 1.0 percent over the last two months in the hope that lower borrowing costs will stimulate growth by making credit cheaper.

Under the terms of Wednesday's loans, the banks will pay the average refinancing rate over the three years. The ECB reviews the rate each month and it will almost certainly change. Banks also have the flexibility of repaying the money after a year if their situation improves.

European officials have said banks need to raise €115 billion ($150 billion) in new capital in 2012 — but finding that money is not an easy task in the current environment of fear. Investors are leery of putting more money into banks and it would be politically unpopular for debt-strapped governments to do it either.

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