Banks took a huge 489 billion euros at the European Central Bank's first ever offering of three-year funding on Wednesday, raising hope a credit crunch can be avoided and that the money may be used to buy Italian and Spanish bonds.
A total of 523 banks borrowed money at the tender with demand way above the 310 billion euros expected by traders polled by Reuters in the run-up to the operation.
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The banks' lunge for funding pushed the euro to a one-week high versus the dollar and sparked a rally in stocks.
The three-year loans are the ECB's latest bold attempt to ease the euro zone's troubles. It is the most the bank has ever pumped into the financial system, topping the near 450 billion it injected with its first one-year loans back in 2009.
Its hope is that the ultra-cheap and ultra-long funding will have a range of beneficial effects, including bolstering trust in banks, easing the threat of a credit crunch and tempting banks to buy Italian and Spanish bonds, thereby calming markets and easing the currency bloc's sovereign debt crisis.
"The take-up was massive ... much higher than the expected 300 billion euros. Liquidity on the banking system has now increased considerably." said Annalisa Piazza at Newedge Strategy, adding that the take-up probably came largely from banks in the euro zone's debt-laden states.
"In a nutshell, the three-year auction can been considered as successful in terms of adding liquidity to the banking sector," she said.
HELP FOR ITALY AND SPAIN?
While an interbank lending crunch may have been avoided, it is much less certain banks will use the money to buy Italian and Spanish government debt, as French President Nicolas Sarkozy has urged, given the competing pressures on them to cut risk, rebuild capital and lend to business.
"While this might help to address recent signs of renewed tensions in credit markets and support bank lending, we remain skeptical of the idea that the operation will ease the sovereign debt crisis too as banks use the funds to purchase large volumes of peripheral government bonds," said Jonathan Loynes, Chief European Economist at Capital Economics.
Given those doubts, most market experts say only more aggressive and direct buying of government bonds by the ECB will help ameliorate the crisis, something it is reluctant to do.
Banks switched 45.7 billion euros out of one-year loans taken from the ECB back in October. The impact on overall liquidity levels was also softened after banks scaled down their three-month borrowing from the ECB to 30 billion euros from 140 billion and almost halved their intake of one-week loans this week.
Rather than a simple flat rate, the 3-year funds were offered at an interest rate which will be the average of ECB's main interest rate over the next three years. That benchmark rate is, after a rate cut earlier this month, at a record low of 1.0 percent.
For some banks the money could be more than 3 percentage points cheaper than they can get on the open market. As part of the deal, as well as being able to convert their one-year money to the new three-year loans, they will also be able to pay it back after just a year if they so wish.
One of the key factors boosting demand is that banks are now more reliant than ever on central bank funds. The ECB on Monday said, in its semi-annual Financial Stability Review, that this dependency could be difficult to cure.
French banks have almost quadrupled their intake of ECB money since June to 150 billion euros, while banks in Italy and Spain are each taking more than 100 billion euros.
ECB President Mario Draghi has been pressing banks to take the money since announcing the plans earlier this month. He warned of a chance of a credit crunch on Monday and said that euro zone bond market pressure could rise to unprecedented levels early next year.