ECB seeks to calm markets as one-year drain looms

European Central Bank officials scrambled to reassure nervous markets on Tuesday that the expiry of nearly half a trillion euros of emergency loans would not hurt the banking system, though they acknowledged some individual banks might face strain.

The ECB and Eurosystem will do what is necessary to make sure the liquidity is there, Christian Noyer, who heads the Bank of France, told Europe 1 radio.

There are some banks that are in a less good situation that might eventually suffer, but we will make sure that there are no problems and everything goes OK.

On Thursday, 442 billion euros ($544 billion) of one-year loans extended by the ECB -- the first of three one-year tranches offered to commercial banks as emergency support at the height of the global financial crisis -- will expire.

To offset the burden that banks will face in paying back the money, the ECB has padded the date with extra borrowing opportunities for them, including an offer of unlimited three-month funds on Wednesday.

This is expected to prevent any funding squeeze in the euro zone banking system as a whole. But markets worry that some smaller, weaker banks may find it hard to cope with the shift from the security of borrowing 12-month money from the ECB to relying on loans in shorter maturities.

This concern helped push the euro to a lifetime low against the Swiss franc on Tuesday. The three-month Euribor rate, a major indicator for euro lending, rose to 0.761 percent, the highest level since last September, from 0.754 percent on the previous day.

DEPENDENCE

Over the last several months, banks in Spain, Portugal and Greece, countries which face sovereign debt crises, have been increasingly dependent on the ECB for funding as private institutions have become reluctant to lend to them.

But the ECB is determined to wind down its one-year loans as part of efforts to restore normal monetary policy. ECB Governing Council member Ewald Nowotny, responding to a Financial Times report that some Spanish banks were angry at this decision, insisted on Tuesday that one-year lending would not be extended.

The ending of the 12-month tender is accompanied by a number of actions to ensure that there will be no liquidity squeeze, Nowotny said in Vienna.

Spanish Economy Minister Elena Salgado urged the ECB to be aware of the needs of the Spanish financial system, though she did not go as far as asking the ECB to continue one-year lending. She said Spain's banking system was strong.

We know the smaller Spanish banks have been frozen out of the repo market and have had recourse to the ECB for short-term funding, a top Spanish financial source told Reuters.

They could feel the pinch now, but I very much doubt that either the Bank of Spain or the Spanish government would let any of those banks get into real funding trouble, particularly given the fact the weakest lenders, the savings banks, are immersed in merger processes which have been flagged as near completion and successful.

Overall liquidity supply in the euro zone banking system is set to exceed 900 billion euros for the first time ever just before Thursday's loan repayment, suggesting the money markets will have little trouble handling the outflow of funds.

There's plenty of liquidity available to bridge the gap, and there's plenty of money on deposit with the ECB, said Simon Maughan, banking analyst at MF Global in Britain.

NEGATIVE SIGN

Nevertheless, individual banks could face losses on bonds held for trading if paying back the one-year money to the ECB forces them to sell those bonds to raise cash. Spanish banks, for example, might face losses on Spanish government bonds, which have slid in value over the last few months.

Most banks should be able to avoid taking such losses, at least for now, by borrowing unlimited three-month money from the ECB and holding on to the bonds.

A bigger threat to the markets, said Andrew Lim, analyst at Matrix Securities in London, is the risk that demand for three-month money could prove unexpectedly large at Wednesday's ECB tender.

Money market traders polled by Reuters expect banks to borrow 210 billion in the three-month operation, which would be a record high. The results are due soon after 5:00 a.m. EDT on Wednesday.

Since three-month Euribor is far below the 1 percent rate at which the ECB will lend its money, very high demand at the operation would ring alarm bells. It would suggest that more banks than feared had lost access to private funding in the market, and would imply banks remained worried about the health of the financial system and were hoarding funds.

If the amount borrowed is very large, it will send a bad signal to the market, said Lim.

One sign that banks are hoarding funds came on Tuesday when the ECB took bids for one-week deposits at the central bank, an operation designed to absorb the liquidity created by the ECB's emergency purchases of government bonds.

Banks showed little appetite to part with their money, depositing only 31.9 billion euros despite the relatively high risk-free interest rate of 0.54 percent which the ECB was offering. The take-up in the operation was well below the ECB's target of 55 billion euros.

Adding to uncertainty in the markets is the fact that European governments are expected by late July to begin announcing the results of their stress tests of banks.

The tests, which will model the impact of tough economic conditions on banks and eventually cover more than 100 institutions, are being undertaken in the hope they will reassure investors about the health of the financial system.

But there is concern that the tests could discover danger spots among, for example, Spain's small savings banks or Germany's regional banks.

Meanwhile, a smooth passage of Thursday's loan payback might simply focus markets' attention on the expiry of the ECB's two other one-year loan tranches in September and December, and on the prospect of the ECB eventually ceasing to provide unlimited amounts of money in its market operations.

At present, the ECB has pledged to lend banks as much as they want until mid-October, though this date may have to be extended to protect weak banks.

(Additional reporting by Boris Groendahl in Vienna, Sonya Dowsett in Madrid and Andrew Torchia in London; Writing by Krista Hughes; Editing by Andrew Torchia)