ECB Fails to Offset Bond Buys

The European Central Bank failed to attract enough funds to offset the full value of its euro zone government bond purchases for the first time since May on Tuesday, adding to fears the debt crisis is worsening stress on the bloc's banking sector.

Demand at the ECB's weekly handout of limit-free funding also hit a new 2-1/2 year high as the increasingly restricted amount of lending in the traditional interbank market left the ECB as only funding option for a growing pack of banks.

The ECB takes interest-paying deposits from banks every week with the aim of neutralizing the inflationary threat created by its controversial purchases of government bonds.

The bank only managed to draw back 194 billion euros from banks versus a target of 203.5 billion this week.

This adds to a handful of previous occasions it has been shy of its target and is the first time the ECB has failed to fully sterilize its bond purchases since ramping up the program in August to include debt issued by Italy and Spain.

With a shortfall of less than 10 billion euros, and going by previous experience, analysts said they expected the ECB to reclaim this amount in a week's time. Nevertheless, the numbers still sent a quiver through banking markets as they added to concerns that funding is increasingly becoming an issue.

"There may be incentives to hang on to liquidity, there's quite a lot of stress, quite a lot of dislocation in the market and it may well be that a handful of institutions have decided to hang on to liquidity rather than give it back to the ECB," said Societe Generale economist James Nixon.

"What has always happened in the past is that in the next weekly repo for the ECB that shortfall is made up so it is not something that is viewed as particularly significant by the ECB," he added.

Were the sterilization shortfalls to become more persistent, it would add up to the sort of outright quantitative easing the ECB has remained firmly opposed to throughout the last few years of crisis.

"If the ECB's bond-buying program continues to expand -- as is likely to be the case -- then there could be a more permanent imbalance as the amount to be sterilized increases and bank balance sheets decrease," said FxPro economist Simon Smith. "This would amount to QE by accident, rather than by design."

FUNDING RELIANCE

Perhaps of greater concern for policymakers was further signs of banking sector reliance on ECB funding.

A total of 192 banks took a combined 265.5 billion euros at the ECB's once-a-week handout of limit-free seven-day loans on Tuesday, beating the 247 billion that 178 banks took last week and the second week running that demand hit a new two-year high.

Intensifying fears about the financial health of Italy, Spain and other debt-strained countries continue to paralyze the traditional bank-to-bank lending market as banks scale back the number of peers they are prepared to lend to.

This week's take-up of weekly funding was higher than at any point since mid-2009. The ECB will also offer 3-month money on Wednesday, with analysts in a Reuters poll expecting banks to take 50 billion euros in that tender.

"The situation is clearly getting worse and those that are struggling to get funding have to go the ECB," said one London-based money market trader. "Banks that are in the periphery, the ones with the lower ratings are finding it tough," he added.

Where banks can access open markets, the price of borrowing has been steadily climbing in recent weeks despite this month's earlier-than-expected cut in interest rates by the

ECB.

The central bank has already reinstated some of its most potent crisis-fighting tools in recent months in a bid to calm the escalating tensions and is currently mulling the possibility of extending liquidity loans to up to three years, according to central bank sources.

New data on Tuesday also showed that its extensive support measures, which include over 500 billion euros of lending aid and over 260 billion euros of government and covered bond purchases, have pushed the combined balance sheet of the ECB and the euro zone's 17 national central banks to an all-time high of 2.420 trillion euros.