Reason to be cheerful from the ECB

It's "Merry Christmas from the ECB" today, but not, I fear, a happy and prosperous New Year.

The high take-up of the ECB's first three-year lending programme for Europe's banks provides a good reason for the financial markets to be cheerful, which I highlighted in my blog on Monday 12 December. As I said then, this new lending coupled with the reduction in bank reserve requirements and the wider range of assets that will be accepted as collateral makes it much less likely that a major financial institution will run out of money in the very near future.


But as I also said in that post last week, the new lending to banks does not solve the deeper problems at the heart of the crisis of the eurozone. Quite the opposite: it's a reflection of how far governments are from a lasting solution.

The sheer volume of lending today, 489bn euros ($638bn; £407bn) to a total of 500 banks, may also tell us quite how tight the funding situation had become, though the generous terms of the facility surely made it attractive to healthy banks as well.

Will this money find its way, as President Sarkozy has suggested, into the troubled sovereign debt market?

Many in the financial markets seem to think so. The cost of borrowing (or implied yield) on Spanish government debt, for example, has now fallen back towards 5% and the tension in the markets has eased, at least for the moment. We know that this is not the result of any great progress by governments at the leaders' summit.

According to Deutsche Bank, about half of the 442bn euros that the ECB lent to banks in June 2009, in a similar one year facility, was used to buy government debt, much of it Greek or Spanish.

I've gone through the technical niceties of this backdoor ECB support for governments many times here. The key difference for the ECB is that when it lends the money to banks it takes collateral, and if the collateral is a government bond, that debt is discounted (has a haircut), which is related to the current value of that debt.

It's generous. The discount is a lot smaller, for example, than the haircut that the Bank of England would demand. But it is there and it takes the current market price of the debt as a starting point.

That is why the ECB would argue it is not helping directly to lower the cost of borrowing for these governments. It is propping up financial systems, not governments.

This is a slippery distinction in the current circumstances. A better defence of the ECB's position right now would be that Spanish or Italian banks, which are being penalised in the money markets for holding too much "toxic" government debt, are unlikely to fall over themselves to buy more.

So, we might not see banks queuing up to lend their ECB cash to governments. Indeed, given the amount of uncertainty around, we might not see them lending it to anyone at all.

The extra infusion of liquidity should keep the European financial system on life support for a little while longer and lessen the chance that the new year will start with a terrible bang. But it will indeed be an Annus Mirabilis if Europe's banks and governments get through 2012 unscathed.