Sept. 4 (Bloomberg) -- It is considered impolite to notice the elephant in the room, let alone stare at the pachyderm. So kudos to European Central Bank policy maker Nout Wellink, who committed sacrilege last month by pointing out that the financial community is becoming addicted to central-bank funding.

``There comes a point where you take over the market,'' Wellink told Dutch newspaper Het Financieele Dagblad. ``If we see banks become very dependent on central banks, then we need to stimulate them to tap into other financing sources.''

That's easier said than done. The ECB, the Federal Reserve and the Bank of England all face a tricky task in their respective intensive-care units in the coming months -- unhooking the banking world from the life-support machine of easy money without killing the patient.

Central banks have morphed from being lenders of last resort to becoming the first port of call for institutions in need of cash. The twist is that the cash isn't even flowing onward into the hands of business owners and home buyers; it's being hoarded by fearful banks sandbagging their perimeters against the ebb and flow of the deteriorating global economic outlook.

In the U.S., the Fed is funneling cash to commercial banks that are outside its regulatory jurisdiction as well as to the investment banks it oversees. The ECB lent 467 billion euros ($676 billion) last week to banks with operations in the euro area, beating the 389 billion euros it provided in mid-December to ease banks through the end of the year.

Tread Softly

And UBS AG analyst Alastair Ryan reckons banks may have borrowed as much as 200 billion pounds ($354 billion) from the Bank of England's Special Liquidity Scheme, four times more than the central bank envisaged in April.

That profligate approach can't continue indefinitely. Unplugging the money machine, though, will prove to be a delicate task. Combine the usual hoarding of cash that happens as the end of the year approaches with concern that access to the money taps in New York, Frankfurt and London might be rationed, and you have a recipe for disaster in a global money market that is still battered and bruised a full year after the credit crunch began.

U.K. banks, for example, have slashed the amount of money they lend to each other. Lending dropped to 205 billion pounds in July from 635 billion pounds a year earlier, and from a record 656 billion pounds in February 2007, though the Bank of England says the pool of participants it compiles the figures from has shrunk. Similar figures from the Fed suggest U.S. banks cut their credit to each other by a net $231 billion in the first quarter.

Money-Market Dislocation

Three-month money-market rates in dollars are 81 basis points more expensive than the Fed's 2 percent policy rate, compared with an average gap during 2006 of 55 basis points. In euros, the difference is 71 basis points, versus a 2006 average of just 30. In pounds, the figures are 75 against 21.

No matter how dangerous tightening the lending rules might be, central banks will eventually have to turn off the taps. Change is in the air at the ECB, which, as a result of far more relaxed standards than its peers, has become the ATM of choice for many banks. Loans to Spain surged to a record 49.4 billion euros in July, up from just 18 billion euros a year earlier.

ECB policy maker Axel Weber said last month that the central bank must be wary of distorting the market for asset-backed bonds by accepting those securities in return for loans.

``The collateral that we take must also be traded in the market because only then is it priced accurately,'' Weber said. ``We certainly won't tolerate the creation of collateral for central banks only, without the intention of trading them.''

Almost Alchemy

You will struggle, though, to find anyone who doesn't believe that is exactly what banks have done, bundling together risky consumer loans into asset-backed securities specifically to pledge them to the ECB rather than trade them on the market.

``We estimate at least 20 percent of all eligible collateral fails that test and a disproportionate amount of such non- tradable collateral is currently being pledged for liquidity operations at the ECB,'' Meyrick Chapman, a strategist at UBS in London, wrote in a research note this week.

ECB council member Yves Mersch said on Aug. 23 that ``at the margins, there can still be cases where you see dangers of gaming the system.'' The central bank has agreed that the rules need a ``certain amount'' of refinement, he said.

The ECB said today it will increase the gap between the face value of most asset-backed bonds and how much can be borrowed against them, with an additional 5 percent discount for securities that have only theoretical pricing. The tighter rules will be introduced on Feb. 1.

Such tweaks are more like methadone than the cold turkey that the financial markets need, though they are at least a start. If banking, though, is at heart a confidence trick --which is what the events of the past 12 months suggest -- then maybe the smartest way for the central banks to restore that confidence is to show renewed faith in the financial community's ability to stand on its own by withdrawing their support.

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Mark Gilbert in London at magilbert@bloomberg.net

Last Updated: September 4, 2008 10:18 EDT