ECB’s Free Lunch Saves Banks €120B

The European Central Bank’s “free lunch” program could provide up to 120 billion euros in subsidies for private financial firms taking advantage of the ECB’s new low-interest loans.

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More than 500 euro-area banks have borrowed 489 billion euros in the form of three-year loans the ECB offered in a December auction. The loans carry a 1 percent annual interest rate, less than a quarter of the 4.3 percent average yield on on senior unsecured bank debt of all maturities in the past year.

With borrowing expected to hit 1.2 trillion euros after a second auction later this month, banks could be saving 120 billion euros over the next three years. The low-interest loans could boost 2012 bank profits by about 10 percent for lenders in Italy and Spain, said Morgan Stanley.

In hopes of averting a credit crunch, the ECB has been flooding the banking system with cheap money. Any bank in the region can borrow an unlimited amount of money at new low interest rates, so long as they can put up eligible collateral.

“This is very much a free lunch,” said Arnd Schaefer, an economist at WestLB AG in Dusseldorf, Germany. “Banks can get money for just 1 percent and then lend it out for much more.”

Lenders could borrow another 680 billion euros in the second auction of three-year loans on February 29, according to a Goldman Sachs survey of investors published last week, which would raise total borrowings from the ECB’s longer-term refinancing operation, or LTRO, to 1.2 trillion euros.

Lenders are being encouraged by policymakers to use the cash to purchase domestic sovereign debt to help keep down borrowing costs and reduce the risk of default. And so far the program seems to be working. Short-dated securities issued by southern European countries like Spain and Italy have rallied since the ECB announced the offer on December 8.

The ECB is now encouraging all banks, not just those in need of the funds, to participate in the second auction. “There is no stigma whatsoever on these facilities,” ECB President Mario Draghi said in Frankfurt on February 9. “The use of these proceeds is a business decision. Our primary interest is in lending to the real economy.”

At the current interest rate of 1 percent, banks will pay about 12 billion euros in interest a year if borrowing from the two auctions reaches 1.2 trillion euros. Banks would have had to pay 52 billion euros a year to borrow the same amount in the senior unsecured bond market, assuming a 4.3 percent yield, the average over the past 12 months. Over the course of three years, the ECB loans represent a savings of 120 billion euros.

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