Huge demand for ECB's three-year loans

image captionIt is hoped that banks will use the loans to buy eurozone sovereign bonds

Eurozone banks have rushed to take out cheap three-year loans offered by the European Central Bank, borrowing 489bn euros ($643bn; £375bn).

The central bank had originally hoped to lend up to 450bn euros to stop another credit crunch crippling the banking system.

Over 500 banks raced to borrow from the scheme, which was far beyond market expectations.

The euro rose sharply on the news, but then fell back later.

When the plan was announced, French President Nicolas Sarkozy said banks could use the money to invest in eurozone sovereign debt.

However, analysts were uncertain if banks will use the money in this way.

"The very heavy take-up of the ECB's three-year, long-term refinancing operation provides some encouragement that banks' liquidity needs are being amply met," said Jonathan Loynes at Capital Economics.

"But while this might help to address recent signs of renewed tensions in credit markets and support bank lending, we remain sceptical of the idea that the operation will ease the sovereign debt crisis too as banks use the funds to purchase large volumes of peripheral government bonds."

'Positive number'

This was the European Central Bank's first offer of three-year loans and was the largest amount of money the central bank has injected into the financial system, beating the 450bn euros it put in with its 2009 one-year loans offer.

Although the offer was seen as a success, its impact on the eurozone economy is still uncertain.

"This is good. It's a positive number, at the top end of expectations. You have to regard it as a positive result. But it is still short of covering all of the banks' financing for next year," said James Nixon at Societe Generale.

Borrowing money though the ECB's loans and using it to buy sovereign debt has been dubbed 'Sarkozy trade' after the French president encouraged banks to use the money to buy national debts when the loan offer was announced.

However, some suggest the money will just be used to boost bank balance sheets, especially since the ECB lowered its collateral requirements when it announced the loans, enabling weaker banks to apply for the funds.

"A cash for trash mechanism allowing banks to access cheap funds and buy up more sovereign debt - or more likely just shore up their own finances," is how Justin Urquhart Stewart of Seven Investment Management described the scheme.

Carsten Brzeski at ING, said: "The good news is that banks won't have to worry about liquidity for three years and that it has already pushed down government yields, as banks are buying them to use as collateral".

"However, whether the ECB's hopes that the money will filter through to the real economy will be fulfilled remains to be seen."

The success of the offer initially had a positive impact on European stock markets, but the effect was short-lived and in afternoon trade several markets were trading lower on the day.

Turbulent times

The ECB's move comes in the wake of turbulent times for the eurozone that have hit peripheral eurozone economies such as Greece, the Irish Republic and Portugal, and started to affect major economies such as Italy and Spain.

Banks in all these countries have lent large amounts of money to their national governments, and others in the eurozone, by buying sovereign bonds which have, historically, been seen as relatively safe investments.

Interest rates for these bonds, known as yields, have been rising during the past few months, reflecting a higher risk that a country may default. Italian yields, for example, hit a record 7% in November.

The banks that are left holding large amounts of eurozone sovereign debt are in turn seen as risky by money markets who force them to pay more to borrow money.

This situation encourages banks to lend less themselves, which trickles down to consumers and small businesses, which find it harder to get loans.

The ECB's three-year loans are designed to free up lending and avoid the kind of credit crunch that saw inter-bank lending dry up in 2008.

Although the ECB has ruled out lending directly to countries, banks taking the three-year loans at 1% are being encouraged to invest in sovereign debt at 6% to 7%.

This not only provides a lucrative return for the banks, but increases demand for sovereign debt, helping countries such as Italy and Spain that need to raise money.

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