ECB methadone is a tough habit to kick: James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) -The ECB will find it tough to withdraw the financing life-support it has been offering banks, illustrating just how difficult it is to stave off a banking crisis without creating moral hazards. The ECB allows banks to post a wide array of assets as collateral for loans from the central bank.

While this has been important in helping Europe's banks to finance themselves in the past year, it has also arguably encouraged some to exploit the system by designing securities which meet ECB criteria but are filled with shakier loans that would be tough to finance in commercial markets at equivalent rates.

It has also created perverse incentives for institutions world-wide to tailor their collateral and route it via euro zone affiliates. Securities tied to loans to consumers and for auto purchases in Australia and South Korea, for example, have been pledged as collateral, something the ECB probably did not anticipate when the rules were first laid down.

ECB officials have laid down a steady drumbeat of warnings that they will move to reform the system, though it seems that a consensus hasn't been struck.

ECB Governing Council member Yves Mersch, speaking at the Fed's Jackson Hole conference, said there was broad agreement among policymakers for some tightening of the ECB's rules.

Fellow member Michael Bonello of Malta told Reuters in an interview that changes would be moderate and aimed at heading off "undesirable practices."

But Bundesbank head and council member Axel Weber talked a bit tougher.

"The collateral that we take must also be traded in the market because only then is it priced accurately," Weber said in an interview with Bloomberg.

Accepting only collateral for which there is a reliable market price could put banks in the euro zone in an uncomfortable position. Many so-called "retained" deals have been designed to be financed with the ECB and would struggle to find a buyer. While there may be someone out there who would buy the paper, the banks and the ECB might find it is at a price far below where banks are now carrying them on their books.

That could mean further write-downs for banks, further tightening of credit conditions and an increased possibility of systemic problems.

"Any changes from the ECB are likely to place further upward pressure on interbank repo rates," said Meyrick Chapman, fixed income strategist at UBS in London.

MORAL HAZARD OR PRACTICAL IMPERATIVE?

To be fair, the amount financed by the ECB is not much different than it was a year ago. What has changed is the composition. Banks have moved to park the tougher stuff with the ECB where possible and gone to the open market for financing on safer assets.

Willem Buiter, former Bank of England official and London School of Economics professor, took aim at the ECB's collateral policy in a paper presented to the Fed conference at Jackson Hole.

He called on the central bank to publish the valuations it uses to lend against hard-to-price securities.

"There is therefore a risk that banks use the ECB as lender of first resort rather than last resort," Buiter wrote. "Since at least the beginning of 2008, persistent market talk has it that Spanish and Dutch banks may be in that game, getting an effective subsidy from the ECB and becoming overly dependent on the ECB as the funding source of first choice."

Of course we can't know if there is a subsidy if we don't know how the securities were valued.

It is also true that these securities are very hard to value, as the disaster in banking shows. It stands to reason too that the departments within the ECB and its member banks that do the valuing will not be paying as high salaries as do the investment banks that are often on the other side of the transaction.

On balance, it seems clear that banks are taking advantage of the system and are thus being insulated from the consequences of their lending decisions. A pinch of moral hazard, however, may be overbalanced by the alternative; a more capital-starved banking sector, a more credit-starved economy and deeper recessions in parts of the euro zone.

It also highlights interesting tensions within the euro zone. Frankly, the interests of Spain, for example, and the interests of Germany are not very well aligned here. Spain needs this credit to keep flowing in a way that Germany simply does not.

Finally, what the ECB does will have an impact on the economy. If they crack down on collateral it will be that much tougher to raise interest rates.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: saft@thomsonreuters.com --

(Editing by Stephen Nisbet)