ECB move averts crunch but risks remain Whether it is a "game changer," a "life raft" or "buying time," the consensus is that the European Central Bank's €489bn three-year loan liquidity shot last month has averted a credit crunch for the region's banks. The mood in markets has shifted since the start of the year. The ECB's "back door" quantitative easing, as some have dubbed it, has triggered a rush by banks across northern Europe to raise funds in the wholesale markets. Bank bonds have rallied the most since 2009. At the same time, short-term borrowing costs for the peripheral nations of Italy and Spain over those of Germany have fallen. With the sovereign crisis inextricably linked to the ability of many banks to raise funds at a reasonable cost, policymakers are anxious to know how long the ECB's longer-term refinancing operation can work its magic and where exactly the money is being deployed. According to research by Morgan Stanley, Italian banks were the single largest users of the ECB's funding programme, tapping a third of €489bn on offer, followed by Spanish banks. Lenders across the region struggled to raise funds in wholesale markets in the second half of 2011. So far this year, only highly rated northern European banks have been able to sell covered bonds and senior unsecured debt. The LTRO, Morgan Stanley estimates, has helped Spanish and Italian banks meet between 50 and 150 per cent of their 2012 pre-funding needs. Take-up of the ECB's facility, however, was not confined to those in peripheral nations. The research suggests there was no stigma to tapping the LTRO: northern European banks, particularly in France, used the facility to meet their own first-quarter funding requirements. For northern European banks, even those in the UK that cannot tap the facility directly, the LTRO has provided a soothing injection of liquidity, helping to calm markets after months of turbulence during which fund-raisings slowed to a crawl. Some of that money should start to turn up in the "real" economy, for example funding companies and trade finance deals. The LTRO has taken "the risk of a systemic banking crisis off the table," says Huw Van Steenis, banking analyst at Morgan Stanley. It should also slow down deleveraging by the banks. But, to be clear, that does not mean deleveraging will stop. Mr Van Steenis says that, while the LTRO is being used to refinance debt, some domestic banks are playing a "carry trade," encouraged by the ECB's very cheap three-year loan facility to invest in short-dated sovereign debt in their home markets. One banker describes a "xenophobic trade" in Spain, for example, where domestic banks are using the LTRO to buy government bonds. Banks outside the periphery, meanwhile, are dumping sovereign debt from countries such as Spain and Italy. In a €10bn auction of Spanish debt, as much as 90 per cent of the investors were domestic. If that trend continues when banks gain access to the second LTRO in February, some argue it could store up problems for the future. Helen Haworth, head of European interest rate strategy at Credit Suisse, says: "If, for example, local banks are stuffed with sovereign debt and we ended up with a situation where Greece, Italy and Spain all need haircuts, that loss would ultimately sit with the ECB." David Lloyd, head of institutional portfolio management at M&G Investments, says the LTRO does not address the issue of bank solvency and capital adequacy ratios. "Banks still face fairly stiff hurdles getting to the right capital position by June," when lenders will have to hit a new 9 per cent core tier one capital ratio, a measure of balance sheet strength, set by the European Banking Authority, says Mr Lloyd. As the markets digest LTRO round one, the focus is shifting to take-up of round two. Mario Draghi, ECB president, suggests that the take-up for February's LTRO could be slightly lower than for the first tranche. How the markets respond will be important. "Is it going to be a huge trillion euros or a damp squib and much lower than the last take-up?" asks Suki Mann, head of credit strategy at Société Générale. "Each extreme sends quite a different message," says Mr Mann. If it is closer to the trillion, the hope is that it gives the market a huge amount of confidence through perpetuating the carry trade, as we'll see greater lending into the broader economy. If the take-up rate is low, we have a problem.