ECB lending push may founder as toxic assets loom

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.

Euro-zone banks raised 20.4 billion euros in equity in the first half of 2009, Thomson Reuters data show, a record for any first half and the third-highest half-yearly figure ever. here

They could also boost their balance sheets by selling off shaky units, but few rivals have the financial firepower to pick up the assets, while private equity houses balk at the thought of a series of bad loans blowing up in their faces.

"At some stage there will be a dam bursting," one head of one private equity house said at an off-the-record briefing, explaining why he did not target banks.

Banks are cautious in pulling the plug on borrowers because they cannot afford to take the hit of a bankruptcy. Instead, they often choose to delay maturities and relax loan terms, prompting protracted debt restructurings.

At the same time, they are protecting themselves from the risk of future loans going bad by tightening credit standards, cutting back the size of loans and stopping others.

Annual growth in private sector loans slowed to a record low of 1.8 percent in May and flows have been negative for three of the last six months.

The ECB's last bank lending survey showed banks expected to keep tightening credit standards in the current quarter, although by less than in Q1, citing capital concerns as well as the dismal economic outlook.

Another sign of their concerns is a widening gap between rates in money markets and corporate bonds, with the spread between three-month euro Libor and the investment-grade Markit iTraxx Europe index now at 120 basis points, compared to 100 a month ago.

Tullett Prebon economist Lena Komileva said spreads would narrow if banks were lending more. "Lenders' focus seems to be on capital preservation," she said.

"The fact that this is not happening means that lenders are more concerned that this margin does not compensate them for the risk of loss of capital that would happen if loans went bad."

CONTRADICTORY?

Economists said the ECB funds would be of most use to banks if they used them to invest in bonds and shares that offer them a return on the money. In the longer-term, this improves banks' profits, allowing them to rebuild capital, write down debt and lend more.

"Improved banking sector profitability will go a long way towards alleviating the problems that we currently face," Societe Generale economist James Nixon said.

A promise from European Union policymakers to focus on building up banks' capital buffers in good times, and running them down in bad times, will also help. [ID:nL6397910] In the short term, analysts said it was contradictory for policymakers to press banks to lend more and at the same time, demand they clean up their books by deleveraging. "You can't do both," said Fortis's Kounis.

For the ECB's financial stability report, please see: here

(Additional reporting by Kirsten Donovan, Steve Slater and Tessa Walsh in London; editing by Patrick Graham)