Just what do you get for a trillion euros?

A trillion is a seriously large number. Counting E500 notes at the rate of one per second, it takes a lifetime (63 1/2 years to be more exact) to get to one trillion euros.  In two operations over 10 weeks, under the new leadership of Mario Draghi,  the ECB lent this much to the European banking system at a fixed rate of 1% for a term of 3 years and backed by much weaker collateral requirements than it has historically permitted.

The net new liquidity provided to the banking system is about half of this, the other half reflecting the expiry of other ECB lending facilities which these operations have replaced. Balances held at the ECB by the banking system have risen by about E500bn over the same time period. So for now the ECB has lent money to the banks at 1% and the banks have re-deposited it with the ECB at 0.25%. The banks however have about E750bn of bond issues maturing in 2012, and so they now have a far less pressing need to borrow in the financial markets to refinance these maturing bonds – it was this huge refinancing requirement which, at the end of last year, had brought fear to the markets of another 2008 event in which the banking system froze and plunged the world into  a savage recession.

So Mr Draghi is credited with finding a solution to the eurozone’s banking liquidity crisis which threatened markets last November and December. In response the bonds and equities of banks have risen sharply and pushed up the prices of securities all over the world in 2012. In particular sovereign bond yields in Italy and Spain have fallen sharply as investors expected that many eurozone banks would use the new liquidity at 1% to buy these sovereign bonds offering much higher yields. The numbers suggests that this has not actually happened, or at least not yet, but the prevention of a crisis has pushed prices higher anyway as confidence has returned.

A full 3 cheers for Mr Draghi is not appropriate though. First, financial markets have read this operation as the European equivalent of Quantitative Easing and this together with the stated desire of Central Banks in the US, the UK, Japan and Switzerland to print more of their own currencies, has sent the gold price rising sharply as well. This has terrified the German Bundesbank which has also realised that in effect these operations have meant that the ECB has acted as lender of last resort, a role it has historically not seen as part of its remit. Further the ECB’s willingness to accept much less secure forms of collateral for this lending, because some of the weaker banks were running out of secure collateral means that the ECB itself could become theoretically insolvent in a further crisis. German support for monetary union as a result of the recent steps, is clearly weakening both amongst the people and politicians and within the Bundesbank.

Secondly, this may not do much to boost the public sentiment towards banks because it seems unlikely that much, if any, of this money will find its way into the real economy via higher lending. Instead it is likely that banks will use it to make an arbitrage profit – some UK banks have already announced that they will not be paying bonuses to their staff based on such profits, indicating that this is the strategy they will adopt for this money.. In addition, in 3 years time, this huge amount of money is due to be repaid – this could create liquidity problems for the banking system all over again. Although the ECB will be likely to be able to manage this over time, withdrawing liquidity from the system nearly always has negative effects on the real economy.

The most serious concern is that although dealing with bank liquidity issues these operations do very little for the bank solvency problems that beset so many banks within the eurozone. Lending them new money is not the same thing as providing the much-needed new capital which can then be used to offset the substantial bad losses that still need to be written off. In fact, this trillion euros has merely created even more debt in an effort to solve the problems caused by too much debt, and since this new money is owed to the ECB who demand priority over all other creditors, all other creditors have implicitly been diluted!