ECB lending push may founder as toxic assets loom

By Krista Hughes and Douwe Miedema - Analysis

FRANKFURT/LONDON (Reuters) - A bold change of tactics in the European Central Bank's efforts to kick-start everyday lending still looks helpless in the face of the mountain of bad assets crippling banks' capital.

In the last two weeks the ECB has dumped close to half a trillion euros in 12-month money into markets, and central bankers and politicians have ramped up exhortations for banks to lend the cash on and allow Europe to spend its way out of recession. But banks still have a long way to go cleaning up the pool of toxic assets left behind by the credit crunch, and there is little visibility on who is most exposed, making the lenders wary to put further capital at risk.

"It's only a short-term solution, it means they have enough liquidity but this can never be a solution to problems of inadequate capital," Fortis economist Nick Kounis said.

The ECB estimates euro zone banks still face another $283 billion (174.3 billion pounds) in write-downs by the end of the next year, as complex fixed income products that helped cause the crisis continue to fester, while the downturn causes bad loans to soar.

Banks would have to raise 240 billion euros (206.4 billion pounds) extra in top-grade capital to reach benchmark debt-to-asset ratios and shed 6 trillion euros of assets, according to estimates in the ECB's latest Financial Stability Report.

As a result companies have had to sell shares and bonds rather than borrowing money from cash-starved banks to rebuild their balance sheets, refinance maturing debt, or expand.

LIQUIDITY GUYS

The ECB's injection of funds has brought down the cost of funds traded between banks to record lows and allowed banks to refinance shorter-term investments -- but it provides little to plug the gaping capital hole.

Overnight money market turnover has actually fallen as banks try to digest the huge cash boost, worrying about the solvency of fellow banks and the chance of another freeze in interbank lending if a big name were to land in trouble.

Many banks have parked the funds borrowed from the ECB at 1.0 percent back at the central bank for a return of 0.25 percent, pushing deposits to record highs.

"Even those banks that see an opportunity in lending-on are constrained by their credit/liquidity guys, who are still so nervous about ... dodgy assets that they won't free-up credit to lend," one money market trader said.

"To look at it from the point of view of a liquidity manager ... losing 75 basis points a day is small change because you're funded for the year no matter what happens."

Experts say it is also unrealistic to expect banks to increase lending in the middle of a recession, when demand is falling and loan default rates rising, adding to pressure on banks to raise capital and cut back on outlays.

CAPITAL CONCERNS

Options for banks to boost capital include retaining earnings -- difficult because profits have plunged in the wake of the crisis -- government rescues, and new equity.