* Covered bonds purchases mark next stimulus step
* Market reaction muted
* ECB to start buying ABS in Q4 (Adds market reaction, background, detail)
By Eva Taylor and Blaise Robinson
FRANKFURT/PARIS, Oct 20 (Reuters) - The European Central Bank has started buying covered bonds, an ECB spokesman said on Monday, opening a new front in its battle to revive the euro zone economy and keep deflation at bay.
The ECB has already given banks the opportunity to borrow four-year loans and will also start buying bundled loans or asset-backed securities (ABS) later this year, having now cut its main interest rate to almost zero.
By taking some of these assets off banks’ balance sheets, the ECB hopes to entice banks to lend more freely again, which is crucial for the euro zone economy as it relies largely on bank funding.
The market reaction to news of the covered-bond purchases was muted. Shares in euro zone banks outperformed, with Banco Santander up 0.9 percent, Societe Generale up 0.8 percent and UniCredit up 1.6 percent. But the FTSEurofirst 300 was down 0.4 percent.
Investors have set their sights on the release of the results of the ECB’s bank health checks on Sunday, which is set to give the clearest picture yet of what state the euro zone banking sector is in.
Covered bonds are debt backed by pools of home or commercial property loans, and 90 percent of the global market is based in Europe, especially in Denmark, Germany, Spain, France and Sweden.
The ECB will also start buying ABS some time in the fourth quarter, it said earlier this month, and will offer another round of four-year loans at ultra-cheap rates in December.
The ECB hopes that these steps will ease lending conditions and generate positive spill-over effects to other markets, which in the end should revive the economy and help bring inflation back towards its target of close to but below 2 percent.
Euro zone annual inflation stood at 0.3 percent in September and has been in what ECB President Mario Draghi has called “the danger zone” of below 1 percent for almost a year now.
The ECB said the latest stimulus measures combined would have a “sizeable” impact on its balance sheet, which it aimed to return towards levels last seen in early 2012. It stood around 3 trillion euros then.
The ECB’s balance sheet reached just above 2 trillion euros in early October. (Reporting by Eva Taylor in Frankfurt and Blaise Robinson in Paris; Editing by Paul Carrel and Hugh Lawson)