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ECB eyes supervisor role to squeeze weak banks

Outside view shows the Euro sculpture in front of the headquarters of the European Central Bank (ECB) in Frankfurt September 18, 2008. REUTE
Outside view shows the Euro sculpture in front of the headquarters of the European Central Bank (ECB) in Frankfurt September 18, 2008. REUTE

By John O'Donnell

BRUSSELS (Reuters) - The European Central Bank could use its new supervisory role from next year to single out weak banks and make it harder for them to get its financial support, people familiar with the matter say.

Such a hardening of approach would keep ECB funding flowing to Europe's most important lenders but compel laggards to beef up their capital buffers, prod national central banks to take on the problem or even force some banks to go to the wall.

The thinking denotes a growing concern at the ECB, which bankrolls much of the financial system, about the risks of backing banks with often only weak collateral as security.

It follows an unprecedented public threat by the euro zone's central bank to cut emergency financing to Cypriot banks, in the middle of the Mediterranean island's crisis which led to the closure of one as part of a stringent bailout.

"Central banks provide liquidity against collateral. But what do you do for addicted banks?" said one person familiar with ECB thinking.

"If a bank returns continuously to get liquidity, (the ECB) will make it more difficult. You will have to pay a higher price. You will have to change the rules for provision of liquidity."

The ECB declined to comment. It gave 1 trillion euros of cheap three-year loans to banks last year and has offered further unlimited support since.

The possible use of such tactics is also a response to the constraints the ECB may face when it takes on bank supervision next year. German opposition could mean there is no separate agency to close problem banks although it is unclear if the ECB would accept this and take on supervision nonetheless.

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Currently, the ECB relies on national regulators for information about banks that borrow from it but that will change when it takes over as overarching regulator next year.

Once it has this power, the ECB could use its knowledge to identify banks with threadbare capital, demand they beef up this cushion or face expulsion from its financing operations, said another person familiar with the new supervision scheme.

Such a move could effectively close a bank, putting a question mark over the notion that there will be a strict division between ECB's role as supervisor and as guardian of monetary policy.

"The supervisor can say this bank's collateral is not of the required standard and that it needs more capital," said that person, adding that a bank could be disqualified from ECB finance if it did not recapitalize within months.

Such a step would not erode wider support for the banking sector but would mark a shift to a more targeted approach, focusing help on those strong enough to thrive.

"Being supervisor allows the ECB to discriminate between zombie banks and those that are sound and make sure that its lending targets those banks that lend to the economy - not to the zombies," said Daniel Gros of think tank, the Centre for European Policy Studies.

Many at the ECB are concerned about the problems lurking in banks, which have piled up billions of euros of bad loans during years of runaway lending.

And yet the necessity to support the sector has led to a loosening of collateral rules which means that banks are often allowed to borrow with second-rate security - sometimes as little as a car loan.

This leaves the ECB with threadbare cover should any sizeable chunk of the almost 850 billion euros it has lent not be repaid.

As it stands, any euro zone bank that has the collateral required qualifies to borrow from the ECB. But this could change if it were to penalize certain banks, by charging them more.

The move would reinforce the ECB's stamp of authority as supervisor, the first step to creating a banking union or system for policing, controlling and supporting banks in the euro zone.

In its new role, the ECB may have to slug it out with national regulators over whether troubled banks should be kept alive. By choking off liquidity, it can avoid a protracted political tangle and shut the bank or force national central banks to shoulder the burden of financing it.

(Additional reporting by Paul Carrel and Annika Breidthardt. Editing by Mike Peacock)

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