ECB May Toss Rule Book On Bond Collateral: Report

The European Central Bank may soon ease its lending standards in what appears to be an effort to prevent Spain's sovereign debt crisis from worsening, according to reports published Thursday. But the move could also impair the credibility of the ECB.

The ECB classifies government bonds, typically used as collateral when institutions borrow from the ECB, into tiers according to how their creditworthiness is gauged by Moody's Investors Service, Standard & Poor's -- both based in New York -- and Toronto-based Dominion Bond Rating Service (DBRS). London-based Fitch Ratings, a subsidiary of a French company is not used to avoid a conflict of interest. The ECB requires more collateral when it includes government bonds that are poorly rated and less collateral when it includes government bonds that are highly rated. For example, loans backed by German bunds require less collateral than those backed by Italian bonds.

Recently, Moody's and S&P downgraded Spanish government debt, and DBRS is expected to soon follow with its own such downgrade.

Under current ECB rules, such an action would move Spanish obligaciones into a lower tier of creditworthiness, forcing the central bank to require billions of additional euro in collateral from the already struggling Spanish banks that have loans outstanding with the ECB.

It also would force ECB borrowers who use bonds from Spain and other weak euro zone nations as collateral to sell those bonds for more highly rated government bonds. That, however, would increase the already sky-high yields of bonds from Spain and other such economies.

Such a development would be catastrophic for Spanish banking and, by extension, for Spain itself.

On Thursday, Reuters and German newspaper Die Welt reported that the ECB is considering scrapping its current policy on collateral to minimize such a fallout from the widely expected DBRS downgrade of Spanish government bonds.

A source described as an insider by the news wire also said the bank is considering softening rules on loans backed by mortgage-backed securities, and action which, again, would mostly benefit Spain's banks. The move would be taken in coordination with other central banks.

We are not yet there operationally, but this may well be the medium-term solution, the source told Reuters.

It is unclear how the ECB would address the moral hazard scrapping its current collateral rules to address a crisis entails. Also unclear is how much any future downgrade of Spain's bonds will affect collateral rules applied to private lending.

Finally, any such change could impair the ECB's credibility as the collateral deposited with it becomes less and less valuable with each credit downgrade.