Mersch Says ECB to Announce Changes to Collateral Rules Soon

By John Fraher

Aug. 25 (Bloomberg) -- The European Central Bank will announce changes to the rules governing its money-market auctions in coming weeks to head off the risk of abuse by financial institutions, council member Yves Mersch said.

``At the margins there can still be cases where you see dangers of gaming the system,'' Mersch said in an interview on Aug. 23 in Jackson Hole, Wyoming. ``The Governing Council has been discussing the whole issue'' and has agreed on a ``certain amount'' of refinement to the existing rules, he said.

ECB officials have become increasingly concerned that banks are taking advantage of collateral rules that are broader than those used by the Federal Reserve and the Bank of England. The danger is that banks struggling to sell securities damaged by the credit-market turmoil will dump them on the ECB and become overly reliant on central-bank funds.

Dutch policy maker Nout Wellink said in an interview with the Het Financieele Dagblad newspaper published Aug. 21 that banks shouldn't become too dependent on the ECB for funding.

``It's not a broad-based revolution,'' said Mersch, who is attending a meeting of central bankers and financial officials organized by the Fed. ``We are satisfied with our framework. But since there are always on the margins evolutions, we have to adjust our framework regularly to market practices.''

``The precisions'' planned by the ECB ``concern some instruments,'' Mersch said, declining to elaborate. Unlike the Fed and the Bank of England, the ECB hasn't had to change its operation rules since the credit crisis began.

Lender of Last Resort

``The ECB is in an unenviable situation,'' said Paul McCulley, a fund manager at Pacific Investment Management Co, in an interview at Jackson Hole. ``The lender of last resort should be just that, a last resort, and not a permanent provider of funds to the private sector.''

Central bankers including Federal Reserve Ben S. Bernanke met in the Teton Mountain retreat at the weekend to discuss ways to address the past year's credit rout. ECB President Jean-Claude Trichet said ``we are still in a market correction'' and Bank of Israel Governor Stanley Fischer said the crisis has yet to run its course.

Spain's banks in particular are struggling to attract investors as a decade-long property boom ends and mortgage delinquencies soar to the highest in at least six years. Investors demand higher rewards to buy bonds backed by Spanish mortgages than any other home loans in Europe. The ECB lent Spanish banks a record 49.4 billion euros ($73.1 billion) in July.

Demand From Outside

The ECB's money market system is also attracting demand from outside the euro region. The Frankfurt-based central bank said in June it will accept asset-backed bonds sold by Macquarie Group Ltd., Australia's biggest securities firm, and backed by Australian consumer loans as collateral.

U.K. mortgage lender Nationwide Building Society said Aug. 18 it's planning to expand into Ireland, a member of the euro region, to take advantage of ``funding opportunities.''

Banks with operations in the countries sharing the euro can raise funding from the ECB by pledging certain types of collateral including asset-backed securities. Bonds backed by mortgages and other assets accounted for 18 percent of the ECB's loan collateral at the end of 2007, up from 4 percent in 2004, Fitch Ratings data show.

The ECB lends to banks mostly through the main refinancing operations maturing in one week. Longer-term auctions provide financing to banks during three- and six-month periods.

`Moral Suasion'

Mersch said the central bank prefers to tackle individual instances of abuse problems with ``moral suasion.''

``Our framework is complex, and if we can warn people that this is not acceptable beforehand, and they adjust in due time, we would be satisfied,'' Mersch said. While the ECB hasn't yet taken ``specific action,'' the central bank plans to strengthen its powers. He didn't say what that action might be.

Mersch said the ECB's response to any abuse case ``would not necessarily be a question to be discussed publicly.''

The financial crisis is taking its toll on Europe's economy, which contracted in the second quarter.

Mersch said ``the question is whether the slowdown will last a little bit longer'' and Bundesbank President Axel Weber, who was also in Jackson Hole, said Aug. 22 the current quarter may show ``some weakness.'' The economy may expand below its potential rate of 2 percent ``into next year,'' he said.

At the same time, ``you shouldn't be getting too hung up about the volatility in quarter-to-quarter GDP readings,'' Weber said. Weber and Mersch both said inflation will exceed the ECB's 2 percent limit next year, with Weber saying there's a ``substantial risk' that price pressures will persist. The ECB will publish revised projections next month.

To contact the reporter on this story: John Fraher in Jackson Hole, Wyoming at jfraher@bloomberg.net