BANKS BOUGHT BONDS AMID DEBT CRISIS / THE NEW YORK TIMES ( HIGHLY RECOMMENDED READING )

September 5, 2010

Banks Bought Bonds Amid Debt Crisis

By JACK EWING

FRANKFURT — Even as Europe’s sovereign debt crisis intensified early this year, banks continued to load up on debt from Greece and other countries with the most acute fiscal problems, according to a report released Sunday that also suggested that the European Central Bank inadvertently encouraged institutions to increase their risk.

Banks increased the amount of credit they extended to government and the private sector in Greece, Ireland, Portugal and Spain by 4.3 percent, or $109 billion, in the first quarter of 2010 compared with the previous quarter, the Bank for International Settlements said. The additional credit brought banks’ total exposure to the four countries to $2.6 trillion. The B.I.S., located in Basel, Switzerland, serves as a clearinghouse for the world’s central banks.

European banks increased their holdings to the four countries more than banks from the United States or other places outside of Europe, possibly because banks in the euro zone could use debt from Greece and the other countries as collateral for low-interest loans from the European Central Bank, the B.I.S. said in its quarterly report.

The E.C.B. has been lending euro-zone banks as much as they want at 1 percent interest, provided the banks can put up collateral like government bonds. The massive liquidity has helped weaker banks survive periods when they were unable to borrow from other banks or outside investors.

The fact that higher-risk European debt was less liquid, or harder to sell quickly, “was less of a concern for euro-area banks than for other banks since the former could ‘liquefy’ this debt in their operations with the E.C.B.,” the B.I.S. said.

The data suggest that the E.C.B. was effectively encouraging euro-zone banks to buy debt from Greece and the other troubled countries. The policy supported Greece and Spain as they sold new bonds but also meant that euro-zone banks were taking on more risk at a time when the E.C.B. had been trying to stabilize the European financial system.

The E.C.B. has been trying to dial down its support for euro-zone banks, but last week extended the policy of unlimited lending to banks at least through mid-January, amid signs that some institutions are still unable to raise all the money they need through normal interbank or market channels.

The E.C.B. has tightened its criteria for the collateral it accepts since the period covered by the B.I.S. statistics. The bank now imposes so-called haircuts of as much as 29 percent on government debt used as collateral, meaning that banks cannot borrow at the full face value of the bonds. That policy could reduce the incentive for banks to buy the riskier debt.

German and French banks continued to be the most heavily exposed to debt from the countries on the periphery of the euro zone. French exposure to Greece alone was $111.6 billion, though only $27 billion of that was government debt. The rest was credit to Greek businesses and individuals, derivatives contracts or other categories. German banks’ exposure to Greece totaled $51 billion, of which $23.1 billion was government debt.

U.S. banks hold $41.2 billion in debt or other exposure to Greece, like derivatives contracts, the B.I.S. said. Only $5.4 billion of that sum was government debt.

German banks were particularly exposed to Ireland, with total exposure of $205.8 billion, exceeded only by British banks, with $222.4 billion. Almost all the German credit to Ireland was in the private sector, the B.I.S. said.

The B.I.S. did not give any information on individual institutions, but Germany’s high exposure to Ireland probably stems at least in part from Hypo Real Estate, a bank in Munich. Hypo Real Estate’s subsidiary in Dublin suffered massive liquidity problems after the global financial crisis became acute in late 2008. The German government stepped in to rescue Hypo Real Estate, and now owns the bank.

Officials from the Group of 20 nations voiced confidence about the global economic recovery at their meeting over the weekend in South Korea, a top I.M.F. official said, Bloomberg News reported from Seoul.

There are “obviously risks and challenges, but things seem to be moving more or less in the line with our forecasts,” said John Lipsky, the second-highest-ranking official at the International Monetary Fund, said Saturday.

Mr. Lipsky also said that the agenda for changes in the I.M.F.’s board representation and quota system made “good progress.”