ECB Lending, Liabilities Surge to Records After `Drastic' Steps

By Simon Kennedy

Oct. 21 (Bloomberg) -- The European Central Bank's lending to banks and its exposure to possible collateral losses jumped to records last week as the battle against the credit crisis forced it to shoulder more risk.

The Frankfurt-based ECB said it loaned banks 773.2 billion euros ($1.02 trillion) through monetary operations, up from 739.4 billion euros a week earlier and a 68 percent surge from the first week of September. Its liabilities to financial institutions rose to 470.3 billion euros, an increase of 4.4 percent from the previous week and up 123 percent from the start of last month.

The ECB is following the Federal Reserve and other central banks in combating the credit crunch by expanding its balance sheet as it injects more cash into the banking system. The downsides include taking on more risk as it accepts weaker collateral when lending.

``The urgency of the situation means that drastic measures need to be taken,'' said David Mackie, chief European economist at JPMorgan Chase & Co. ``Up until a month ago the balance sheet wasn't growing. Now the bank is creating more and more money.''

The ECB became more aggressive after the collapse of Lehman Brothers Holdings Inc. on Sept. 15 prompted banks to hoard cash worldwide. To spur lending, the central bank has loaned money for longer timeframes and offered banks unlimited amounts of dollars and euros. It last week loosened rules on the collateral it will accept when making loans to include lower-rated securities, certificates of deposit and subordinated debt.

Demand for Cash

With the financial crisis spilling over into the economy, demand for banknotes has also jumped. The value of notes in circulation rose to 721.8 billion euros, an increase of 9.7 billion euros from the previous week and 5.4 percent from the start of last month, today's ECB data showed.

The combination of increased banknotes and liabilities means so-called high-powered money in the economy has now grown 33 percent since the first week of September. While defensible given the need to end the 14-month credit crunch, Mackie said such gains leave the central bank sitting on lower quality collateral, banks more reliant on public cash and the economy facing an inflation threat when a recovery begins.

When Lehman Brothers sought bankruptcy protection, its Frankfurt division owed between 8 billon euros and 9 billion euros to the ECB, the Wall Street Journal reported Oct. 7, without saying where it obtained the information.

`Increasing Our Risks'

ECB President Jean-Claude Trichet has said that while the bank is assuming more risk, it is doing so because of the greater threat of financial meltdown. ``We have made decisions which are increasing our risks,'' Trichet said in an Oct. 19 interview with France's RTL Radio. ``We are facing a systemic liquidity problem of first importance.''

The ECB's risk-taking may be paying off. The cost of borrowing euros for three months fell to the lowest level today since Lehman filed for bankruptcy on Sept. 15. The euro interbank offered rate, or Euribor, for such loans dropped 3 basis points to 4.97 percent today, the European Banking Federation said.

While the U.S. Treasury last month sold government securities to help expand the Fed's balance sheet, Natacha Valla, a former ECB economist now at Goldman Sachs Group Inc., said there is currently no need for euro-area governments to bolster the ECB's accounts. Still, national central banks in countries where the financial system is bigger than the economy, such as Luxembourg and Ireland, may require more capital at some point, she said.

To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net