Cash-starved banks in the 17-nation eurozone snapped up almost €500bn (£417bn) in cheap three-year funding from the European Central Bank in an attempt to head off a credit crunch.
Reflecting the strains on the European financial system caused by market jitters over potential bank losses from a break-up of the single currency, demand for loans from the ECB was much stronger than expected.
Small gains in stock markets after the ECB announced the details of its long-term refinancing operation (LTRO) were wiped out and bond yields on Italian and Spanish debt rose. The interest rate on 10-year Italian bonds rose to 6.8%, while 10-year Spanish bond yields edged up to 5.3%. Equity markets were also concerned by the financial fragility of European banks exposed by the demand for loans, with the FTSE 100 closing down almost 30 points at 5389.74 and the Dow Jones posting a four point gain after being down most of the day.
Analysts expressed scepticism about the likelihood that banks would heed the advice of French president Nicolas Sarkozy, who has urged institutions to use the loans to buy the bonds of troubled economies on the fringes of the eurozone, thereby bringing down the crippling level of interest rates faced by countries such as Greece, Ireland, Spain, Portugal and Italy. They also expressed concern that Europe's banks were becoming ever more reliant on the ECB for funding as other sources dried up.
The ECB said 523 banks had borrowed €489bn under the new lending arrangement, and analysts said the large-scale take-up showed that institutions felt that there was no stigma attached to applying for the loans. For some banks, the ECB funding comes with interest rates more than three percentage points lower than they could obtain on the open market.
Dario Perkins, economist at Lombard Street Research, said the net impact would be smaller – at about €200bn – because the new three-year loans were replacing one-year loans. Perkins added that he expected the ECB's action to buy time but said the underlying problems remained unresolved.
"We can envisage a scenario in which the recent policy response in Europe – including from both politicians and the ECB – brings a period of relative calm at the start of 2012. Indeed, recent sentiment among investors, who are almost universally bearish, makes that a distinct possibility. But we remain deeply sceptical about how long this period of calm can persist without a real fiscal union."Jonathan Loynes, chief European economist at Capital Economics, said: "The €489bn allocation was much bigger than the €200bn to €300bn anticipated. But while this might help to address recent signs of renewed tensions in credit markets and support bank lending, we remain sceptical 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."
While the ECB has resisted pressure for it to join the Bank of England and the US Federal Reserve in creating electronic money through quantitative easing, the Frankfurt-based institution was keen to bolster the financial strength of European banks ahead of what is expected to be a choppy start to 2012. Italy alone faces about €150bn of debt refinancing early next year and the latest data showed its economy – the eurozone's third largest – shrank in the third quarter.
The news agency Reuters said Italian banks alone tapped more than €110bn in the new funding arrangement. One source from a Spanish bank said nearly all Spanish banks had participated in the three-year ECB auction and taken up between €50bn and €100bn.
Europe's wider financial crisis deepened on Wednesday when Standard & Poor's downgraded Hungary's credit rating to junk status. S&P warned that Hungary, which has asked the International Monetary Fund for a €15bn-€20bn credit line, is suffering from the weakening global economy, and its own domestic problems. Many Hungarian mortgages are priced in Swiss francs, meaning households have suffered as the forint has lost value in the currency markets. The move was attacked by Hungary's economy ministry, which accused S&P of a deliberate attack on the EU.
Separately, America was warned that its credit rating could be cut unless US politicians agree a credible debt reduction strategy. Fitch said that America's rising debt burden was "not consistent" with a AAA credit rating, but indicated that any downgrade would probably not come before 2013.
