ECB's dilemma on the euro rescue It has been little more than two months since the European Central Bank conducted the second of two three-year longer-term refinancing operations. After veering dangerously close to the edge of another financial cliff, markets were jerked back to safety by the ECB's actions. Given the scale of these measures - injecting nearly €1tn into the eurozone banking system - it is striking how short the respite has been, and pressure is again building. Where are we going? Head-on into a policy dilemma borne out of fear and complacency. Fear is a powerful incentive to wait and hope. Outside the smaller peripheral economies of Greece, Ireland and Portugal, neither eurozone creditor governments nor indeed the International Monetary Fund wants to open the Pandora's box of loans to the larger periphery economies of Spain and Italy. To do so would expose the folly of a tiny eurozone firewall and the unfathomable possibility that sovereignty is transferred from two of the bloc's largest economies to Brussels. So it is better to hope against all hope that the Spanish will fix Spain and the Italians will fix Italy, rather than to formalise realistic contingency plans for minimising the cost of de facto currency crises in these economies. Complacency stems from a belief, thus far confirmed by events, that the ECB will act as a lender of last resort to sovereigns, at least indirectly via the banks. Investors and policy makers alike assume the ECB will simply repeat its late 2011 actions. The key point is that the eurozone's current firewall relies, at its core, on collateralised lending to stressed periphery banks. The lack of good collateral is the Achilles heel of this rescue strategy. As periphery banks" balance sheets shrink, so, naturally, do the asset bases with which they can borrow from anyone on a securitised basis. These banks will be inclined to run out of eligible collateral again and again as they are forced to finance foreigners exiting the periphery. Accordingly, another massive liquidity injection will only be possible if the ECB accepts ever riskier collateral or assumes smaller haircuts on its existing collateral. But there is evidence, from the commentary of several national central bank governors since the LTROs, that they are extremely averse to doing so. Their comments echo those of their respective governments, underscoring that risk-sharing through the back door is becoming just as difficult as debt mutualisation, in the form of common eurobonds, through the front door. Last year, ECB president Mario Draghi had to wait until banks were at the precipice of collapse in order to garner a consensus for action among the hotchpotch of hawks and doves that make up the ECB's governing council. At that point, there was little question, legal or practical, about the prudence of the actions he took. This time there is. Hence the dilemma. The ECB has thus far acted like a prudent central bank. While acting liberally in agreeing to accept riskier collateral, it chose to require national central banks to hold the riskiest securities on their balance sheets. Now, any losses on the new, riskier collateral will be borne solely by the NCB that oversees the borrowing private bank. These NCBs are thus incentivised to pick carefully what types of collateral they accept. The central banks have imposed haircuts averaging 53 per cent on the new collateral, implying that for every €100 of collateral posted by the banks, they receive only €47 of cash liquidity. In this respect, Mr Draghi is fully justified in stating that the ECB has acted to insulate itself from the unprecedented balance sheet risk it is taking. But safe lending practices mean less relief for the banks. And in the present context, high haircuts mean less collateral available for refinancing purposes in moments of extreme need. If a bank loses €1 of private funding, whether through deposit flight or the loss of access to private wholesale markets, it still needs to fund €1 of new funding. A dwindling pool of "good" bank collateral raises doubts about how long the eurozone's crisis response can muddle along. Private lenders, cognisant that a competing loan by the official sector - collateralised or not - subordinates their own interests, either seek as much of the best collateral as they can find, or simply stop lending. The ECB can, as before, save the day by taking ever larger default risk on to its balance sheet, but it cannot have its cake and eat it. The current crisis narrative involves ever more collateral transfer from periphery to core and ever more subordination of private sector interest to the official sector. It may allow a muddled middle way between default and debt mutualisation to go on, but there is no clear exit strategy. At best, the ECB's actions have succeeded in making the crisis more chronic than acute, with private investors waiting for the next LTRO to get out. Gene Frieda is a global strategist for Moore Europe Capital Management