ECB should incentivise banks to buy bonds

THE European Central Bank should draft commercial lenders as allies in its fight to stem the euro-region financial crisis by giving them incentives to buy bonds of debt-swamped governments, Deutsche Bank says.

In his proposed “Plan B,” London-based Deutsche Bank economist Gilles Moec said the ECB would limit collateral for one-year central bank loans to investment-grade sovereign paper rated less than AAA, encouraging purchases of debt sold by Spain, Italy, Portugal and Ireland. He also suggested a “margin-call holiday,” freeing banks from providing more collateral if the value of the swapped bonds falls.

“Investors still don’t know whether to buy from the periphery,” Moec, a former Bank of France official, said in a telephone interview. “But the rates the periphery are paying should be quite tempting so it wouldn’t take much for investors to start buying their debt.”

German 10-year bonds slid on Wednesday, sending the yield on Europe’s benchmark government debt securities, to more than 3% for the first time since May as the regional crisis cooled. Irish bonds rose, cutting the extra yield investors demand to hold the securities instead of German bunds to the least in a month, after the Dáil passed an initial series of budget votes.

Moec’s proposal would take the pressure off the ECB to keep buying the bonds of Ireland, Portugal and Spain to calm markets as European policy makers squabble over how to contain spreading debt losses. The ECB bought the most bonds since June last week, helping reverse debt-market declines.

The ECB said last week it would continue to keep offering banks as much cash as they want through the first quarter over periods of up to three months at a fixed interest rate. Moec’s plan, which he said could complement the current liquidity programmes, would reduce the collateral the ECB would be willing to accept when lending for a year. Among the assets excluded would be the government bonds of the six euro-area nations with AAA ratings such as Finland and Germany.

In addition, to helping reduce yields in the most-strained markets, the plan would give governments breathing room to cut their budget deficits, yet not let them off the hook for doing so because the collateral would re-enter the market after a year, Moec said.

“Governments would in effect be given 12 months to demonstrate to the market their capacity to address their fiscal issues, which reduces the moral hazard,” he said.

Curbing the ECB’s bond buying may prevent further divisions among policy makers concerned that the central bank’s balance sheet is growing too much, Moec said.

The ECB bought almost €2bn of bonds last week as President Jean-Claude Trichet pledged to fight “acute” financial market tensions.

One risk to the Deutsche Bank proposal is that the ECB will have to renew the plan in a year’s time just as it has delayed withdrawal of emergency liquidity measures, Moec said. Germany, whose central bank chief Axel Weber has already questioned the bond buying programme, also may object to the ECB’s taking on extra risk by not making margin calls, he said.

For its part, Deutsche Bank’s total net exposure to central and local governments in Portugal, Ireland, Italy, Greece and Spain totalled €10.1bn at the end of March, according to a July 27 presentation.

To address potential weaknesses in his proposal, Moec suggested the plan be combined with governments making long-term commitments, such as strengthening the rules for fiscal discipline in the euro-area.

The ECB also may first require Portugal to accept a bailout before following through on his idea, Moec said.

The central bank should indicate it will raise its benchmark interest rate from a record low 1% in 2011 if the overall 16-nation economy merits such a shift, he said.

“The anticipation of higher interest rates would appease the authorities of the core countries,” Moec said.

While the idea requires coordination challenges, Moec said the May rescue of Greece in which the ECB began buying bonds for the first time shows overcoming those are “not unachievable in times of extreme pressure.”