Thursday, September 4, 2008

ECB Will Tighten Lending Rules to Stop Bank Abuse (Update2)

By Christian Vits

Sept. 4 (Bloomberg) -- European Central Bank President Jean- Claude Trichet made it harder for financial institutions stung by the year-long credit crisis to exploit its lending rules.

Trichet said he'll make it more expensive for banks to borrow from the ECB against most asset-based securities from Feb. 1. The ECB will increase the so-called `haircut' on the securities to 12 percent from as little as 2 percent, meaning it will lend just 88 percent of the value of the paper. Paper without a market price faces an additional 4.4 percent discount.

The ECB is concerned its money-market rules are being abused by banks trying to unload securities damaged by the credit rout in return for central bank funds. Europe's financial institutions stepped up their borrowing from the ECB, whose lending rules are looser than the Bank of England's, after the U.S. subprime mortgage collapse derailed financial markets a year ago.

``This is clearly bad news for the profit and loss of banks, especially Spanish and Irish-based ones, that have retained asset- backed securities,'' said Luca Jellinek, head of interest-rate strategy in London at Royal Bank of Scotland Group Plc. ``ECB financing is a significant feature of their balance sheet.''

The cost of protecting European bank bonds from default soared to the highest in five months after Trichet announced the changes to the so-called haircuts, or risk premia, it applies to collateral. Credit-default swaps on the Markit iTraxx Financial index of subordinated debt of 25 European banks and insurers climbed 13 basis points to 178, the highest since April 1, according to JPMorgan Chase & Co. prices at 4:10 p.m. in London.

`Gaming System'

The ECB said it will raise the haircut on unsecured bank bonds by 5 percentage points.

ECB council member Yves Mersch foreshadowed today's announcement when he said in an interview in Jackson Hole, Wyoming, last month that the central bank is concerned that some financial institutions are ``gaming the system.''

Trichet made today's announcement after the ECB left its benchmark interest rate at 4.25 percent. He said the central bank remains focused on fighting inflation even after cutting its economic growth forecasts for this year and next.

The bank today lowered its 2008 economic growth forecast to about 1.4 percent from 1.8 percent and raised its inflation forecast to about 3.5 percent from 3.4 percent.

`Uniform' Risk Premium

Trichet said the ECB will apply a ``uniform'' risk premium of 12 percent on asset-backed securities. This haircut is meant to protect the ECB against a decline in the value of the assets.

The ``valuation haircuts'' on asset-backed securities currently range from 2 percent to 18 percent. The rule changes increase the haircuts in 10 out of 12 categories of the securities.

The value of the underlying asset is calculated as the market price less the haircut. An increase in the haircut therefore reduces the amount that can be borrowed, making banks more dependent on investors who are demanding higher returns before committing funds.

Trichet said the ECB hopes that the changes ``will have a positive impact'' by helping the market become ``more active.''

``We don't think it would hamper the way the system is functioning,'' Trichet said. ``It's a small fraction in the present total amount of collateral.''

The share of asset-backed securities deposited as collateral with the Eurosystem jumped by a third last year. Asset-backed securities in 2007 amounted to 16 percent of the total deposited.

`Burning House'

``The situation on the credit market is like a burning house and central banks are unsuccessfully trying to extinguish the flames,'' said Janwillem Acket, chief economist at Julius Baer Holding AG in Zurich. ``The crisis is far from over.''

Spain's banks in particular are struggling to attract investors as a decade-long property boom ends and mortgage delinquencies soar to the highest in at least six years. Investors demand higher rewards to buy bonds backed by Spanish mortgages than any other home loans in Europe.

``Spain will be especially hit because they were large issuers'' of asset-backed securities, said Sylvain Broyer, an economist at Natixis in Frankfurt. ``If market conditions don't improve'' by the time the measures are implemented, ``it will hurt banks' earnings.''

At the moment, banks holding Spanish asset-backed securities can get money cheaper at central-bank auctions than through investors. A Spanish mortgage-backed bond rated at the highest credit rating trades with a spread of about 3 percentage points to the euro interbank offered rate, or Euribor. The resulting rate of 7.96 percent compares with an average rate of 4.74 percent at last week's ECB auction for three-month money.

Still, the Bank of Spain said the changes to the ECB's collateral rules will have no impact on the funding position or profits of Spanish lenders.

The new restrictions will reduce the amount of money Spanish banks can borrow from the ECB against asset-backed securities by at most 14.4 percent, said a central bank official who asked not to be named. That still leaves the Spanish financial system with a ``very large'' amount of surplus collateral, so banks will see no change in the cost or availability of central bank funds, the official said.

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