ECB Signals No Intentions To Finance Governments But Relaxes Criteria On Eligible Collateral

Heading into the ECB rate setting meeting, speculations about major policy changes were running high. Not only most people were expecting at least a 25 basis points rate cut to the interest rate on the main refinancing operation of the Eurosystem to 1.0%, many were also hoping for rules on acceptable collateral by the ECB to be relaxed. An initiative aimed at providing easier access for banks to central bank money. Moreover extending the terms of the loans provided by the ECB from a maximum of one year to three years was also seen as a potential way to help banks secure access to liquidities and give them more confidence to extend credit to households and corporations.

Today, the ECB delivered on those expectations. It lowered its policy rate by 25 basis points and will relax criteria on eligible collateral. Moreover the ECB will conduct two longer-term refinancing activities wit a maturity of 36 months and an option to early repayment after one year. The first operation will take place on December 21.

In regards to collateral eligibility, the ECB is reducing the rating threshold for certain asset-backed securities (ABS) to those having a second-best rating of at least single A with the underlying assets comprising residential mortgages and loans to small and medium-sized enterprises. Moreover, national central banks will be allowed, as a temporary solution, to accept as collateral additional performing credit claims (namely bank loans) that satisfy specific eligibility criteria.

The ECB is also reducing the reserve ratio, which is currently 2%, to 1%. This will free up collateral and support money market activity. This measure will take effect as of the maintenance period starting on 18 January 2012.

Finally, it will discontinue for the time being the fine-tuning operations carried out on the last day of each maintenance period. This is a technical measure to support money market activity.

Press Conference:

European Central Bank President Mario Draghi reiterated in his press conference that the central bank has no intention to circumvent rules that prohibit it to finance governments. In his view, lending money to the IMF exclusively to buy bonds in the euro area is not compatible with the treaty. According to the ECB, the Securities Markets Programme objective is to insure appropriate monetary policy transmission. Credibility as far as national economic policy geared at fiscal stability and economic growth and missing fiscal rules that constraint ex ante indebtedness are what is currently lacking according to the ECB President. For Mr Draghi, it is up to the EFSF and ESM to play the stabilization role.

Commenting on the interest rate decision, Mr Draghi pointed out that the discussions were lively and the decision was not unanimous as far as the timing of today’s rate cut is concerned. The ECB has revised down its forecasts. The mid-point GDP growth forecast for 2012 is now 0.3%, compared to 1.3% previously. The inflation forecast was revised up from 1.7% to 2.0%.

Market reaction:

In the context of the current debt crisis, anything short of announcing more forceful ECB interventions in the sovereign bond market was deemed to disappoint. For many, a true solution to the current crisis necessarily involves the central bank assuming the role of lender of last resort to Euro zone governments. Thus it comes as no surprise that yields to maturity on Italian bonds were up following the ECB press conference (from 6.05% to 6.40%) and stock markets in Europe were down. All eyes are turning on the EU summit starting tonight in Brussels.