Money markets ecb funds ease financial stress, dangers ahead

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* Dangers to over-reliance on ECB funding flagged* ECB and banks taking on more risk on balance sheets* Feb LTRO seen easing financial stress in money marketsBy Ana Nicolaci da CostaLONDON, Feb 1 European Central Bank liquidity has helped to lower the level of financial stress in the inter-bank market and improve sentiment towards risk, but analysts are beginning to flag the dangers of a banking system over-reliant on cheap central bank funding. The three-month spread between Libor rates and overnight index swap rates has narrowed since the ECB injected money in the financial system in December and is seen tightening further as the central bank is set to offer another round of three year loans this month. There is a widespread view that the ECB's liquidity operations have been successful in averting a credit crunch which would have accentuated the euro zone debt crisis. But there are concerns banks may get too comfortable and the ECB may struggle to wean them off cheap lending."The worry is this a temporary life-support or is this something that is going to be hard to reverse in future?" Richard McGuire, senior fixed income strategist at Rabobank said. Even with three-month euro zone Libor interbank lending rates at their lowest since March 2011 at 1.04943 percent , traders say banks have remained reluctant to lend to each other.

"We don't think that it actually tackles the root of the problem which is one of solvency and at its heart a lack of fiscal union in the euro zone," McGuire added. European leaders agreed to a pact of stricter budget discipline, a step towards tighter fiscal integration, helping to fuel risk appetite in financial markets already benefiting from ample ECB liquidity. The injection of nearly half a trillion euros of three-year ECB funding in December has seen the spread between three-month Libor rate and overnight Eonia rates - a measure of counterparty risk - tighten more than 20 basis points since December. The spread last stood at 69 bps, unchanged from the day prior.

Simon Smith, chief economist at FxPro expects that gap to narrow another 20 basis points after the second round of three-year funding this month. The ECB is expected to allot 325 billion euros in its second three-year refinancing tender due in late February so long as money markets remain stressed, a Reuters poll of traders showed this week. DAY OF RECKONING

The problem was how to wean the banks off such attractive funding conditions and what impact it could be having on the ECB's growing balance sheet, analysts said."If you give banks the easy option it sort of blunts the need to make the harder choices," Smith said. Given the ECB has eased its collateral requirements quite significantly, "from having a very liquid, stable balance sheet, the ECB has gone to having a very large and less stable balance sheet by nature of the risks that it is taking on in terms of the paper it is receiving."The ECB's long-term refinancing operations (LTRO) have allowed domestic banks to borrow at relatively attractive rates with the ECB to buy high-yielding bonds, making a profit but also increasing these banks' exposure to riskier sovereign debt."Banks become increasingly vulnerable to a turn in peripheral sentiment because they will be more heavily invested in peripheral bonds so any decline in the value of those bonds is going to hurt balance sheets an awful lot more if they have loaded up on them via the LTRO process," McGuire said. It also delayed the "day of reckoning" which will ultimately involve a solution that transfers some of the risks to Europe's paymaster Germany and other so-called "core" countries either via greater fiscal union or quantitative easing by the ECB, he added."At the moment this three-year (cash) is helping the carry trade. So banks are going out and buying a huge amount of government debt for anything under three years and using the ECB to fund it," a trader said. "It's great in the short-term ... but what happens in three years' time when the ECB stops that?"