European Central Bank Ready To Flood Market With Cheap Euros

The European Central Bank is ready to engage in an aggressive new expansion of the continent's money supply this week, flooding European banks with hundreds of millions of euro worth of cheap financing meant to prop up the tattered European banking and sovereign credit funding systems.

At 10:20 a.m. London time (5:20 a.m. New York time) Wednesday, that supranational monetary body will announce the amount European banks have borrowed during the latest round of long-term refinancing operations, under which the European Union's central bank provides ultra-cheap loans to banking institutions with a three-year maturity.

The loans, the first round of which was disbursed in December 2011 to 523 banks and totaled €489 billion ($656 billion), are being made available at a one percent interest rate and are specifically designed so that banks needing the money will find it relatively easy to qualify. The purpose of extending the easy credit is to prevent the euro-denominated credit markets, which have been under considerable stress since last summer, from seizing up.

Indirectly, the loans help lower the borrowing costs faced by European sovereigns, as banks commonly place the cheap funding in intermediate-term national bonds, hoping to make a profit on the difference between the one percent cost of the borrowed money and the yield on sovereign debt, which can exceed five or six percent. That practice is known as engaging in an interest carry trade, and is highly profitable assuming the interest rate environment remains on track in the near future, and the international financial system does not collapse.

Because the loans are being offered to, and not forced upon, the banks, it is not known how much money the European Central Bank will report as having lent under the program until Wednesday. Estimates by bank economists across the world have varied widely, with consensus suggesting a figure somewhere between €300 and €450 billion. Yet some estimates suggest the take-up could be as high as €1 trillion.

That high estimate reflects just how aggressively the ECB is working to promote liquidity in the continental banking system, to the point of taking over the market function normally performed by the private interbank lending system.

If the whole system was to borrow the whole amount offered, which the central bank is ready to offer in principle you could live with the shutdown of interbank lending for three years, Jürgen Odenius, chief economist at buy-side Prudential Fixed Income, said.

For a lender of last resort to say, we're pushing the market aside for three years, that's remarkable.