ECB cuts interest rates, loosens reins on loans

December 8, 2011

The European Central Bank took new measures Thursday to bolster the continent’s ailing economy while dampening expectations that it would escalate its efforts to help struggling European governments borrow money at affordable rates.

The ECB cut interest rates by a quarter percentage point and announced a program to make it easier and cheaper for cash-strapped banks to borrow money from the central bank. Both steps were widely anticipated.

But ECB President Mario Draghi stoked the concerns of global investors by telling reporters that the central bank would not print money to buy government bonds. Many government officials in Europe and beyond have been urging the ECB to expand its purchases of bonds issued by Italy, Spain and other countries as a way of boosting market demand for the bonds, thereby bringing down interest rates that have approached prohibitive levels.

Draghi’s comments at a news conference in Frankfurt immediately drove up the interest rates that several heavily indebted countries must pay to borrow money.

The rate Italy must pay to borrow money for a decade soared by nearly half a percentage point, to 6.43 percent, and Spain’s rate rose 0.4 percentage points, to 5.75 percent. Even France, which remains in relatively strong financial shape, saw its borrowing costs rise 0.14 percentage point to 3.3 percent.

These rising rates further ramped up the pressure on European leaders, who are meeting in Brussels for a potentially fateful summit aimed at resolving the continent’s debt crisis.

In a separate action Thursday, the European Banking Authority said European banks would have to raise about $150 billion as a buffer against possible losses. About $40 billion of this buffer would be to cushion potential losses on troubled European government bonds held by the banks.

If the banks respond to the mandates by cutting back on lending, this could further crimp economic activity at time when Europe is already showing signs of a new recession.

And if the banks cannot raise the new money from private investors, Europe’s governments may have to come up with the cash — much as the U.S. government pumped capital into U.S. financial firms as part of the 2008 bank bailout. This could further stress European governments, which are already facing financial difficulties.

To address what Draghi called a “significant downward revision” in the economic outlook, the ECB slashed its main target for short-term interest rates to 1 percent from 1.25 percent. The central bank has now fully reversed its rate increases from earlier in the year, essentially acknowledging that the debt crisis afflicting many European nations could be dragging the continent back into recession.

In expanding its program to support the financial sector, the ECB began offering unlimited amounts of three-year loans to banks. It had previously offered one-year loans.

The ECB also relaxed its rules for what it will accept as collateral for the loans. Banks have had increasing difficulty coming up with high-quality collateral amid mounting concerns about the quality of government bonds and other assets.

The ECB meeting was only the second for Draghi since he became president, and he has cut interest rates at both of them. At the same time, Draghi said the central bank’s governing council did not discuss any efforts to cap the rates that governments must pay to borrow money, which they often need to keep operating. As fear over possible government defaults has spread in recent months, government bond yields have been spiking.

“While the ECB met expectations of a further cut in interest rates and greater support for banks today, it shattered hopes that it is about to fire a silver bullet into the heart of the debt crisis,” said Jonathan Loynes of Capital Economics in a report.

Draghi, who previously headed the Italian central bank, is playing a delicate game. By withholding ECB relief for weaker European governments, he is keeping pressure on political leaders to make difficult choices needed to stabilize the euro currency. But critics fear that if Draghi refuses to budge, he could precipitate a breakup of the euro currency zone.

“I don’t think it’s really useful to speculate on breakups or things like that,” Draghi told reporters. “In spite of everything, it seems quite far-fetched.”

The EBA report highlights some of the same concerns about the health of the European banking system that led the central bank to expand its lending and other programs.

It also showed how some of the banking system’s recent problems are self-inflicted.

According to EBA data released Thursday, major financial companies such as Germany’s Deutsche Bank and France’s BNP Paribas participated in the sell-off of European government bonds that pushed down the value of those investments and weakened the European financial system as a whole.

Compared with earlier EBA statistics from July, Deutsche Bank, for example, reduced its Italian bond holdings from $10 billion at the end of last year to around $4 billion as of Sept. 30.

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