ECB liquidity support “is not a panacea”, says Moody’s

European banks are likely to increasingly rely on funding from the European Central Bank (ECB) although this could have a number of negative consequences, according to Moody’s.

On December 22 the ECB offered three-year loans to the continent’s banks and witnessed strong take-up. The central bank is set to carry out another auction on February 28 in a bid to boost the liquidity of the eurozone’s banking sector.

In its weekly credit outlook, Moody’s points out that the ECB’s efforts will create a number of benefits for the region’s banks – including a sharp reduction in the risk of defaults caused by illiquidity.

In addition, the move will allow banks to continue to lend to the wider economy and permit them to invest ECB funds into longer-dated government securities to earn a positive spread.

“But ECB support is not a panacea,” Moody’s continues. “Euro area banks will likely replace some of their maturing unsecured debt in 2012 with collateralised ECB funds, which we consider credit negative.”

The ratings agency also says that increased use of ECB support will increase funding concentration risk while exposing them to political decision-making processes out of their control.

Furthermore, banks’ relationships with investors could be damaged by their prolonged absence from private funding markets. “These negative effects are particularly relevant where elevated central bank reliance becomes structural rather than just temporary,” Moody’s adds.

The outlook also points out that many of Europe’s financial institutions are facing challenges that cannot be addressed by central bank action. These include the weakening of sovereign creditworthiness, restricted willingness for governments to support banks and an environment of more costly and restricted market funding.

“Plentiful ECB funds do not remove the need for fundamental business model changes, they merely afford banks time to adjust to a more difficult environment,” the ratings agency concludes.