June 30, 2010 10:13 pm

The ECB begins to make for the exit

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It is right to withdraw some of its support for banks

Even the longest march starts with a single step. The European Central Bank has started to withdraw some of the emergency support it provided to eurozone banks during the crisis. While vigilance is needed to ensure that this process does not precipitate another upset, it is to be welcomed.

What the ECB has done may seem technical. It has obliged banks to repay €442bn of emergency one-year loans they took out when it offered unlimited cheap funds against collateral. In place of this lifeline, it has offered unlimited liquidity to all comers – but for just three months at a time.

This change is not without impact. The reduction in the term puts additional pressure on banks that elect to continue leaning on the ECB for money. They may run the risk of the collateral they deposit being subjected to greater haircuts every quarter. With three-month loans, troubled banks could be pushed into difficulty faster than with one-year loans.

Yesterday’s roll-over – the biggest test of this approach – went encouragingly. Eurozone banks rolled over just €132bn of the €442bn into the new, shorter-term facility. This suggests many are sufficiently confident about their access to funding to require less of a liquidity buffer.

This does not mean the banking system is out of the woods. Many institutions, especially in southern Europe, remain fragile. The ECB has been criticised in some quarters for adding to their woes by tightening its funding terms.

The ECB must take care not to turn the screw too hard. It would be unfortunate if a precipitate withdrawal of support tipped the banking system back into crisis. Yet it is far from clear that applying a little more pressure to banks is a bad thing from a public policy perspective. The ECB’s approach seems proportionate. It continues to offer unlimited liquidity, keeping the price low while winding in the length of the lifeline. There should be no funding crisis if the banks are solvent. But they will be kept on their toes by having to refinance more regularly.

The ECB was right to offer unlimited one-year liquidity a year ago. When the interbank markets froze, the reason was ill-understood and people were fearful, so calming things down was the sensible thing to do. It is clear now that the problem is doubt about bank solvency. What is needed therefore is to separate the sheep from the goats, exposing the weak and insolvent banks. The steady withdrawal of support will make it harder for these to hide their losses. To move to a world where emergency measures are unnecessary, such banks must be dealt with. This does not mean being bailed out by the taxpayer. Creditors of weak banks should be forced to share the pain.

If fresh crises erupt, it may be necessary to return to emergency mode. But the financial system has coped with this tightening. The best way to avoid a relapse would be to dispel the doubts about the banks one way or another. The next step must be rigorous stress-testing.

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