ECB move weakens impact of ratings agencies for banks

FRANKFURT Fri Sep 28, 2012 4:57pm BST

A Spanish flag flutters in the wind in front of the dome of Bank of Spain headquarters in central Madrid September 24, 2012. REUTERS/Sergio Perez

A Spanish flag flutters in the wind in front of the dome of Bank of Spain headquarters in central Madrid September 24, 2012.

Credit: Reuters/Sergio Perez

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FRANKFURT (Reuters) - A little-noticed move by the European Central Bank is likely to encourage Spain to apply for a bailout and lessen the impact of ratings agency downgrades on euro zone debt.

Effectively, the ECB is now saying that if a country applies for European Union bailout aid, the ECB will automatically allow banks to use that country's government bonds as collateral, even if they are rated as "junk" status.

Previously, there had been no guarantee that it would, even though it had done so for some troubled countries.

Spain, which has said it will apply for a bailout in the right circumstances and which is currently under scrutiny by ratings agencies, may thus feel more confident that going for a bailout will not hammer its banks.

The move also fits with a wider European push to curb the influence of rating agencies, which have been blamed for helping to sow the seeds of the 2008 financial crisis and playing a key role in the euro zone debt crisis. The agencies have also come under fire in the United States for their decisions.

The change is technical but significant.

Under ECB rules, if the four ratings agencies it considers significant downgrade a euro zone country to non-investment grade status, generally referred to as "junk", those bonds are no longer eligible to be used by banks as collateral for ECB funding, a key source of financing.

In the case of Ireland, Portugal and Greece, this was waived after they went for bailouts, though there has been some modification for Greece.

The ECB has now formalised that it will happen in all cases where there is a bailout, thus ensuring that junk-rated government bonds of a bailout country could be used as collateral, preventing banks in those countries from having to turn to their national central bank for Emergency Liquidity Assistance (ELA) funds, which would cost them more.

Additionally, it will ensure that the ECB can buy the junk bonds of a bailed out country under its new bond-buying programme - a key element in its attempt to solve the euro zone crisis.

Banks in the "junk" countries themselves would be the main beneficiaries because they tend to hold a lot of domestic bonds. But it would also apply to banks of other countries holding that debt.

HELPING SPAIN

Ratings agency Moody's is close to downgrading Spain, the euro zone's fourth largest economy, to junk status, although it may yet decide that Thursday's budget moves were enough to hold things steady for now.

If it did move, however, and the other three - Standard & Poor's, Fitch and DBRS - followed suit, Spanish banks would no longer be able to use the country's sovereign bonds as collateral for ECB funding.

Nor would French or Portuguese banks or others holding Spanish debt.

But the new rule means that if Madrid applies for a bailout - as its prime minister has said it will if conditions are right - they would.

"It's an additional incentive for taking a programme," said Grant Lewis, head of research at Daiwa. "It provides another safety net because you will still have access to the ECB refinancing operations even if you are downgraded."

Cutting off of collateral could be particularly painful for Spain's banks, which have been shut out of the interbank markets and have to rely on the ECB for funding as financial markets doubt their health.

Spanish banks currently take up more than one third of the ECB's refinancing operations.

PARTIAL SOLUTION

But the ECB lifeline won't shield them completely. Regulators, for example, use credit ratings to determine banks' capital requirements.

"To accept collateral that would not otherwise be eligible is certainly helpful to a banking system in a pressurised country," said Alastair Wilson, chief credit officer in Europe, Middle East and Africa for Moody's.

"But it doesn't resolve the country's problems and therefore doesn't fundamentally resolve the problems that the banking system faces."

Moody's, in fact, assumes that the ECB will act to preserve banks' access to funding in one way or another after ECB President Mario Draghi stressed in July the ECB would keep all liquidity lines open to solvent banks in strained countries.

The ECB began to soften its collateral rules last year as lending dried up in some countries. It gave national central banks the option to accept more loans made to companies or households as collateral and allowed them to tailor the conditions to suit their own banks.

In September, it dusted off another crisis-fighting measure, saying it would accept debt instruments denominated in U.S. dollars, British pounds or Japanese yen as collateral - something it did between 2008 and 2010, the height of the financial crisis.

The ECB estimates that this latter liberalisation could free up around 30 billion euros (24 billion pounds) after writedowns it applies for various things such as type of asset, issuer, and maturity.

The average amount of eligible collateral in the euro zone overall is about 13 trillion euros.

There are also other option the ECB can take to keep the money flowing.

It could, for example, stop charging an extra 5 percent penalty it imposes on sub A-rated government debt. Spain currently does not have to pay that, but only because ratings agency DBRS still rates them highly enough.

(Editing by Jeremy Gaunt and Philippa Fletcher)