July 3, 2014 / 7:02 PM / 4 years ago

UPDATE 1-How does the ECB's four-year loan scheme work?

(Adds detail)

FRANKFURT, July 3 (Reuters) - The European Central Bank will start giving banks the opportunity to borrow four-year loans at ultra-cheap rates from September to encourage them to lend more freely to the euro zone’s real economy.

Here is how the programme, dubbed the targeted long-term refinancing operations, (TLTROs) will work.

Who can borrow?

All euro zone banks with access to central bank funding can borrow from the ECB. Euro zone banks who are not individually eligible for ECB borrowing can borrow through groups led by an ECB-eligible bank. The ECB is allowing the group approach because it wants to support bank lending across the sector.

How much can banks borrow?

Up to 1 trillion euros could be borrowed ($1.36 trillion) in total, ECB President Mario Draghi said on Thursday, citing the ECB’s own projections.

In the first stage, banks can borrow up to about 400 billion euros in operations on Sept. 18 and Dec. 11.

The amount a bank can borrow from the two operations combined is capped at 7 percent of its loans to companies and households in the euro zone, excluding mortgages, as of April 30, 2014.

Banks can borrow more in quarterly instalments between March 2015 to June 2016. How much a bank will be allowed to borrow in these instalments depends on how much they lend to the real economy.

Banks that increased lending to the real economy in the year to April 30 will be able to borrow three times the amount of their additional lending.

Banks that shrank their lending in the run up to the April 2014 cut-off date are projected to continue doing so at a similar rate over the next year to April 2015 before stabilising. Such projections serve as the benchmark.

These banks, too, can then borrow up to three times any increase in their lending over their respective benchmark. There are no repayments over the first two years.

When do banks have to pay the money back?

The ECB will review banks’ lending two years after the programme begins. Banks that fail to meet their individual net lending projections set by the ECB, will have to pay back their borrowings in full in September 2016.

All TLTROs loans will mature in September 2018.

Will banks use the funds to buy government debt again?

There has been concern that banks could take the cheap money and invest it in assets that pay higher returns, such as government bonds, something that could earn them a decent return even it that means they will have to pay the funds back after just two years.

The incentives to do so are lower now than they were in 2011/2012 when the ECB handed out three-year crisis loans and banks embraced the so-called ‘carry trade’.

Banks can now borrow at a cheaper rate in the normal ECB funding operations - 0.15 percent - than the possibly 0.25 percent for the TLTROs, which takes the main refinancing rate at the time the bank takes the TLTRO loan plus 10 basis points.

The thinking is that banks can lock in current low rates until 2018, when interest rates are likely to be higher than now. So having to pay them back halfway is seen as a penalty.

And finally, government bond yields across the euro zone have fallen significantly since 2012 and offer less of an incentive to buy into them to generate higher returns. ($1 = 0.7331 Euros) (Reporting by Eva Taylor; Editing by Laura Noonan and Hugh Lawson)

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