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Massive Lending Operation: ECB's Risky Plan to Flood Banks with Cash

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The European Central Bank has launched the biggest lending operation in its history, and banks pounced on the offer on Wednesday, borrowing almost a half-billion euros for three years at a low interest rate. Governments hope the banks will use the cash to buy sovereign bonds, but critics warn the ECB's strategy is risky and could stoke inflation.

The European Central Bank in Frankfurt has given euro-zone banks a massive liquidity injection. Zoom
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The European Central Bank in Frankfurt has given euro-zone banks a massive liquidity injection.

Central bankers tend to be diplomatic and cautious in their public statements, so the dramatic wording the European Central Bank (ECB) used this week to warn about an escalation of the euro crisis was indeed striking.

Tensions in the financial markets had "intensified to take on systemic crisis proportions not witnessed since the collapse of Lehman Brothers three years ago," the ECB warned in its latest report issued on Monday.

ECB President Mario Draghi told a committee of the European Parliament that Europe's banks faced major dangers in the coming months. "The pressure that bond markets will be experiencing is really very, very significant if not unprecedented," Draghi said.

It will be a tough year for banks. In 2012 overall they will have to pay back €725 billion ($953 billion) in debt, of which €280 billion will fall due in the first quarter alone. They will have to borrow fresh money to service this debt, but it's almost impossible for them to raise that money in the private market. Most of them have large holdings of European government bonds on their balance sheets, so they don't have the mutual trust necessary to lend each other large sums of money.

"The interbank market is pretty shut," said Dieter Hein, a finance expert at Fairesearch, an independent research company for institutional investors, banks and brokers. "Virtually no one outside is lending any money to euro-zone banks any more."

ECB Becomes Banks' Lender of Last Resort

That's why the ECB has become the lender of last resort for many banks. Ever since the start of the 2008 financial crisis it has kept on supplying the banking sector with fresh cash, for up to one year in some cases. On Wednesday, it launched the biggest lending operation in its history, and banks responded by borrowing €489 billion in the ECB's first ever offering of three-year funding -- at an interest rate of just one percent initially.

This carte blanche for the financial sector has whetted the appetite of Europe's policymakers. French President Nicolas Sarkozy said weeks ago that cash-strapped countries could start turning to their banks for credit again if they had sufficient liquidity.

At first sight everyone gains. The banks could lend their cheaply obtained borrowed cash to governments at higher interest rates, and governments would at last be able to find buyers for their bonds again. The ECB might even be able to abandon its own controversial purchases of government bonds.

But critics are sounding the alarm. They say that by bailing out the banks, the ECB is financing governments through the back door. Bill Gross, head of the world's biggest bond investor Pimco, said Europe was simply shifting funds from one hand to the other.

Hugo Beck, economics professor at Pforzheim University in Germany, said the flood of money would eventually stoke inflation. "The ECB is hurling gigantic amounts of liquidity into the market," he said. "It can't control that, it's playing with fire."

Despite all the risks, the plan seems to be working in the short term. In recent days the risk premiums on high-debt euro member states have fallen significantly. Spain was able to borrow twice as much in the market as originally planned, and at relatively low interest rates. The banks are evidently buying bonds again in anticipation of receiving ample ECB assistance.

But the impact could prove short-lived. Experts believe that banks have recently been buying bonds mainly to use them as collateral for borrowing from the ECB. Once they get the central bank cash, the buying spree could quickly evaporate. After all, the financial sector still regards bonds issued by ailing euro-zone states as toxic for balance sheets.

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