Why Thursday could be a scary day for European banks

There's still a lot of dodgy debt swilling around Europe's banking system. And on Thursday, we'll get an indication of just how bad things are as the ECB rolls over €442bn of loans to the banks. John Stepek looks at what's likely to happen.

Austerity is the new buzzword. After the G20 meeting at the weekend, markets are braced for governments to cut back.

But what's really worrying investors is that central banks are talking about cutting back too. There is increasing talk about removing some of the 'monetary stimulus' pumped in via special liquidity schemes and low interest rates and quantitative easing and the like.

And this Thursday may give us a snapshot of exactly what that could mean for markets. Because Thursday is the day when the European Central Bank reviews the terms on around half a trillion euros of the banking sector's overdraft.

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So what might happen?

The ECB wants to stop propping up banks

Just under a year ago, the European Central Bank (ECB) loaned out €442bn at an interest rate of 1%. This was part of its Long-Term Refinancing Operations (LTRO) special lending schemes designed to help banks get through the credit crunch. Banks were allowed to borrow the money by pledging other assets as collateral.

But now that money is due to be repaid on Thursday.

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That doesn't mean that the whole €442bn is going to be sucked out of the system. The ECB is offering the opportunity for banks to roll-over the debt (i.e. refinance it a bit like remortgaging your house). But the terms are less favourable. The ECB will allow banks to borrow for three months at a time, rather than a year. The interest rate remains at 1%, but because it's shorter-term, it increases pressure on banks to find longer-term financing elsewhere.

So what's likely to happen? There are a few scenarios. None are terribly reassuring.

On the one hand, most banks would rather get replacement funding in the market, rather than from the ECB it's cheaper. But if more banks are chasing funds, then that will drive up the cost of borrowing. So one side-effect of removing the ECB liquidity, will be to push up the cost of money. That feeds through to everyone else, including us consumers at the end of the line.

If too many banks take out ECB loans, it could spell trouble

But really that's the most optimistic scenario. Because that would suggest that banks are able to get decent access to all the funding they need from the markets. In this case, a rise in lending costs would simply be the result of markets starting to return to something approaching normality.

(Of course, a lack of demand for funds may instead indicate that banks are too scared to lend to anyone, which is also a bad sign. But we'll leave that for now.)

However, at the other end of the scale, the real worry is that the ECB will be flooded with demand for this short-term funding. As Joseph Abate at Barclays notes, if the collateral that banks have been using is poor quality, "there might not be much of an exodus out of the facility." That's because no one else will accept the rubbish that the banks have been handing over to the ECB.

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In other words, if lots of banks take advantage of the ECB's three-month loans, it's a bad sign. "Not only would this indicate that banks still have lower quality assets on their balance sheets but that the decline in market rates since last July has not been broad or deep enough to enable institutions to leave the security of the ECB."

That will make markets more paranoid about the state of the banking sector and the wobbliness of the markets in general. And in turn, that could also drive up borrowing costs as investors become even less keen to lend money to European banks.

Spanish banks for one seem to be panicking. One executive tells the FT: "Any central bank has to have the obligation to supply liquidity. But this is not the policy of the ECB. We are fighting them every day on this. It's absurd."

"The system is just not working," adds Simon Samuels of Barclays Capital. "We're approaching the third year of liquidity support and still the market cannot survive unaided."

This isn't a liquidity problem, it's a solvency problem

But that rather tells you something. What it tells you is that this isn't a liquidity problem. Liquidity problems go away. They're caused by a burst of panic, whereby otherwise perfectly healthy businesses are shot down because they can't access the money they need to conduct their day-to-day business.

The idea is that if the central bank acts as a "lender of last resort" and provides the liquidity, the market will get over its panic, and life will continue as normal. Because there's nothing fundamentally wrong with these businesses. So there's no need to change your business model or acknowledge that there's anything wrong.

Trouble is, there is something wrong with the European banking system. The fact is that there are a lot of bad debts out there. And no one is entirely sure where they're hiding. This isn't about liquidity. It's about solvency. And for as long as that fear is left to fester in the market, the ECB will never be able to let the system stand on its own two feet.

We'll be keeping an eye out for what happens later in the week. But one good thing may come of the roll-over. As Unicredit's Luca Cazzulani puts it on FT Alphaville: "Banks participating in the auction will reveal themselves as players with very difficult market access." So at least we'll have a better idea of exactly which banks seem to be in the most trouble.

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John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.