The European Central Bank seems determined to make the euro crisis worse

06/29/2010 1:25 pm EST


Jim Jubak

Founder and Editor,

Add a new risk to the continuing euro debt crisis: The European Central Bank itself.

The bank’s one-year special liquidity facility runs out on June 30—and the bank has apparently decided not to renew the $543 billion program that supplied liquidity to the Euro Zone banking sector.

The special facility had provided one-year money to banks at 1%.

Instead the central bank will offer a special 6-day funding designed to get banks to the regular offer of 7-day funding next week.

And the central bank, starting tomorrow, will also offer unlimited 3-month liquidity. The odds are that the bank will follow that 3-month offer with other 3-month offerings to carry banks to the end of the year.

As you can imagine, Euro zone banks aren’t thrilled to see a one-year offering replaced by 7-day and 3-month liquidity.

The one-year term of the earlier special facility had provided stability and visibility to banks at a time when the markets for short-term commercial paper still aren’t functioning. In normal times banks would borrow in the short-term in the commercial paper markets and then simply roll over that short-term paper when it matured into new short-term issues. With those markets still closed to many Euro zone banks, bankers worry about their ability to roll over 3-month paper when it matures.

The end of the special facility is part of the European Central Bank’s strategy of gradually ending the extraordinary measures it took to supply liquidity to the financial system after the collapse of Lehman Brothers and American International Group.

No one disputes that the central bank should end these extraordinary measures sometime, but banks are screaming, “Not yet. Wait until the commercial paper market is open to us again.”

Of course, the commercial paper market isn’t going to recover very quickly as long as the European Central Bank keeps flooding the market with cash.

Absent the results of the bank stress tests due to be released in mid-July no one knows exactly how bad off the worst Euro zone banks are or how many banks are in that worst-case group. The stress tests are likely to make it easier for the strongest banks, such as Banco Santander (STD), to raise funds because the capital markets will stop lumping the good and the bad banks together.

But the stress tests, if honest and extensive, are likely to make it even harder for the worst case banks to raise funds.

At that point the European Central Bank is going to have to figure out how to handle the next phase of a crisis that just seems to go on and on and on.

Any hope that the European Central Bank might be able to withdraw from the capital markets is likely to prove rather fleeting.

I’ve got to wonder why the bank thinks that ending the special liquidity facility today is even worth the effort when the next stage of the crisis is just about two weeks away.
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