ECB Inspects Banks’ Lending as Bond Buying Begins

The European Central Bank has begun purchasing covered bonds in its latest effort to lift the European economy and save the eurozone from deflation. The ECB is planning to buy as much as 700 billion euros’ worth of bonds in its latest round of quantitative easing.

The European Central Bank has begun purchasing covered bonds in its latest effort to lift the European economy and save the eurozone from deflation. The ECB is planning to buy as much as 700 billion euros’ worth of bonds in its latest round of quantitative easing.

The ECB has begun with short-dated covered bonds from a number of different issuers throughout the European Union. These bonds are a form of asset-backed security that has a positive cash flow from debts such as mortgages, and are considered one of the lowest risk securities available. The bank is focusing on French and Spanish bonds, but will buy more broadly later in the program.

While the bank has not announced a target amount of bonds it is planning to buy on open markets, ECB President Mario Draghi has publicly stated that the bank is hoping to inflate its balance sheet to the level seen in early 2012. A timetable for the purchases is also unclear, but it will begin announcing the size of its bond purchases next week.

ECB May Overpay for Bonds

However, liquidity issues may drive prices higher for the ECB, according to some bankers. In a note released to clients at the beginning of this month, British bank Barclays said that the ECB’s demand for bonds outstrips the available supply, which could mean higher prices for the securities than their fair market value. “The ECB indicated that it would be ready to hold a share of up to 70% of individual bonds, but we believe that reaching such a high ownership rate could be achieved only when accepting a significant distortion of valuations,” the bank said.

The ECB has twice purchased covered bonds: first in 2009, when the bank bought 60 billion euros of the securities, and again in 2011 when the bank bought less than 20 billion euros. Analysts expect the bank to fall far short of its purchasing target as controversy between the Bundesbank and the ECB limits Draghi’s ability to pay higher prices for the bonds.

Bank Holdings Scrutinized

While the ECB is purchasing covered bonds, the bank is also doing a detailed review of private bank holdings throughout the eurozone. The ECB has publicly stated that it is working with banks throughout the eurozone, but particularly in Italy, Spain, France, and Greece, to analyze their capital levels and to determine which have greater room to increase credit.

In a speech to lawmakers in the European Union, Mario Draghi said that the ECB is attempting to get more clarity about the quality of loans on the books of private banks, but that their review was possibly contributing to a tightening of credit throughout the eurozone. “Although there may be some more loss of blood once it has been properly taken care of, the illness will disappear. The banks will return to lending in a much more robust position,” Draghi said.

In recent months, European entrepreneurs have complained that credit has tightened to the point where they can no longer expand their operations, even if their investments are relatively low risk. The ECB has recently allotted 82.6 billion euros for small-business lending, but little of that money has actually been dispersed as loans. The ECB’s recent purchase of covered bonds is designed to give banks an additional push to lend more aggressively to European businesses.