UPDATE 1-ECB toughens collateral rules for accessing liquidity

(Adds details, market and analyst reaction)

By Krista Hughes and Jane Baird

FRANKFURT/LONDON, Sept 4 (Reuters) - The European Central Bank on Thursday unveiled tougher rules on the assets banks can submit as collateral in central bank lending operations after concern its rules have been open to misuse.

The ECB will increase the safety margin it takes in valuing assets, known as the haircut, to 12 percent across the board for all asset-backed securities (ABS) that banks deposit with the ECB to receive short-term funding and access payment systems.

Banks will also have to take an initial markdown of 5 percent on ABS that are valued based on models, rather than on market prices, taking the maximum haircut to 16.4 percent.

Unsecured bank loans will also have a haircut add-on of 5 percent under the new rules, to take effect on Feb. 1 2009.

Analysts said the changes would make it less attractive for banks to use asset-backed securities as collateral and would push up the overall cost of borrowing funds from the ECB, which lends banks on average more 400 billion euros a day.

"They did not go for the most disruptive option, to remove ABS completely," Bank of America economist Gilles Moec said. "Those banks which really need to use those assets, which are really cash-constrained, can still do so ... but the cost of using this collateral is higher."

The asset class which will be most affected by the changes are ABS with a residual maturity of up to one year, which currently have a haircut of just 2 percent.

Instead of receiving 98 euros in exchange for a security worth 100 euros, banks will in some cases receive just 83.60 euros under the new rules.

"It definitely is becoming more expensive, and you will see demand shrinking and less overall liquidity made available because of the increased haircuts," said Markus Ernst, a structured credit analyst with Unicredit (HVB) in Munich.

"This is a tricky issue, and we have been sorting out the arguments pro and con."

The announcement is the first change to the ECB's rules since the onset of credit market tensions in August 2007. Since then the ECB has joined other major central banks in adding extra funds to markets to bypass liquidity bottlenecks.

Market spreads narrowed initially on the news, but widened again as traders realised the changes would not affect liquidity around the end of the year.

Separately, the ECB announced it would bolster its liquidity offer by rolling over extra three- and six-month liquidity tenders due to expire in coming months.