Draghi Warns Banks Long-Term Loans Can’t Replace Capital

Mario Draghi is signaling that Europe’s banks must get their books in order rather than rely on a fresh round of long-term loans.

“If I had to summarize the view of the Governing Council with respect to liquidity, I would say that nobody wants to have a liquidity accident standing between now and the recovery,” the European Central Bank president said yesterday in Paris after policy makers kept the benchmark interest rate at a record low of 0.5 percent. “Liquidity ought to be provided to the banking system as needed, but it should not be a replacement for lack of capital.”

A pending ECB review of lenders’ balance sheets threatens to overshadow the 17-nation euro area’s fledging economic recovery. While pledging to keep rates low and provide sufficient cash to support growth, Draghi is also pushing for rigor in uncovering any weaknesses in the banking system before the central bank takes over financial supervision next year.

“The ECB will be there as lender of last resort if fundamentally solvent banks get into trouble in funding markets,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London. “But the lender of last resort has no place propping up banks who fail the test with long-term financing.”

Credit Crunch

Central banks acting as lenders of last resort “can generate moral hazard in the banking system, lead central banks to take unwarranted credit risk and, in some extreme cases, interfere with their primary mandate –- price stability,” European Central Bank Executive Benoit Coeure said today in a speech in Toulouse, France. “Support that is considered as appropriate during the crisis might have perverse effects on the incentives of banks at a later stage.”

The ECB helped European lenders overcome a potential credit crunch in late 2011 and early 2012 with two rounds of long-term refinancing operations worth more than 1 trillion euros ($1.4 trillion). As banks have become more confident that the euro area won’t break apart, they’ve used an ECB option to repay those three-year LTROs early, reducing excess liquidity in the financial system and threatening to push market rates higher.

At the same time, global rates started to rise after the U.S. Federal Reserve signaled in June that it would begin to taper the amount of monthly stimulus it provides to the domestic economy, the world’s largest.

Stress Tests

By pledging to keep official interest rates low for an extended period of time and saying he’s ready to offer a new round of LTROs if needed, Draghi has fought to keep market rates under control. The overnight rate that banks expect to charge each other 12 months from now, as measured by Eonia forward contracts, was at 0.22 percent today, compared with 0.3 percent on Sept. 5, the date of the ECB’s last rate decision.

Now, with excess cash in the system near its lowest level since 2011, lenders face a new threat: The ECB’s comprehensive review of bank balance sheets which will include stress tests. Draghi has insisted that the review won’t shy away from identifying capital shortages.

“The whole exercise of the asset quality review and the balance sheet assessment and the stress tests make sense only if they are credible,” Draghi said yesterday.

The European Union’s 42 biggest banks would have had to raise 70.4 billion euros to reach a capital ratio of 7 percent of assets weighted for risk at the end of last year, the European Banking Authority said on Sept. 25. That’s the minimum level allowed under Basel rules scheduled to be implemented globally by 2019.

Sovereign Holdings

Banks that are concerned about what will be found on their own balance sheets or those of their counterparties will want a bigger cash buffer, according to Frederik Ducrozet, senior euro-area economist at Credit Agricole CIB in Paris.

“The risk remains that a tougher asset-quality review weighs on the banks’ ability to lend, as well as on their demand for central bank liquidity in the coming months,” he said. “We continue to believe that another very long-term refinancing operation could be the first line of defense to fall if the ECB needs to put its money where its mouth is.”

The refinancing need may depend on the parameters of the asset review, which the ECB says it’ll announce this month. A key question is how the stress tests will handle banks’ holdings of their own government’s debt. Europe’s nascent banking union was conceived as a way to cut the link between lenders and their home governments, one of the root causes of the sovereign debt crisis, when stressed national economies cause bond prices to drop and weaken bank balance sheets.

‘Necessary Restructuring’

ECB Governing Council member Jens Weidmann, the head of Germany’s Bundesbank, has called for an end to the preferential treatment given to government bonds under EU regulations. Sovereign debt is zero-weighted on bank balance sheets, meaning it doesn’t have to be backed by capital, and there are no upper limits on how much can be held. Draghi said yesterday that “no action is being envisaged or no policy has ever been discussed by the Governing Council” on handling government debt.

Draghi has asked an ECB panel to study options for new bank funding measures as policy makers try to figure out how to deal with any future liquidity shortages, two euro-region central bank officials said yesterday, asking not to be identified because the matter is confidential. The panel has no set date for delivering a verdict, one official said.

“The ECB stands ready to provide banks with as much liquidity insurance as needed to help restore the transmission mechanism of monetary policy, but this liquidity will be provided in a way that will not delay the needed restructuring of the banking sector,” said Marco Valli, chief euro-zone economist at UniCredit Global Research in Milan. “This latter point probably flags some unease with the shortcomings of the three-year LTROs, which led to massive carry-trade activity and postponed the necessary restructuring of the business model of the weakest banks.”

To contact the reporters on this story: Jeff Black in Frankfurt at jblack25@bloomberg.net; Stefan Riecher in Paris at sriecher@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net

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ECB President Mario Draghi

Chris Ratcliffe/Bloomberg

“The whole exercise of the asset quality review and the balance sheet assessment and the stress tests make sense only if they are credible,” Mario Draghi, president of the European Central Bank (ECB), said yesterday.

“The whole exercise of the asset quality review and the balance sheet assessment and the stress tests make sense only if they are credible,” Mario Draghi, president of the European Central Bank (ECB), said yesterday. Photographer: Chris Ratcliffe/Bloomberg

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Oct. 2 (Bloomberg) -- European Central Bank President Mario Draghi speaks at a news conference in Paris about the decision to keep the benchmark interest rate at a record low of 0.5 percent, the euro-area economy and inflation expectations. (Excerpts. Source: Bloomberg/European Central Bank)