ECB Urges Bank Recapitalizations

European Central Bank (ECB) President Jean-Claude Trichet, in his press conference following the central bank’s monthly meeting, built on the more confident tone set in recent weeks. European Central Bank (ECB) President Jean-Claude Trichet, in his press conference following the central bank’s monthly meeting, built on the more confident tone set in recent weeks. Mr. Trichet suggested improved market conditions are a reflection of the decisive and constructive actions taken by eurozone governments.

Quizzed on why interbank lending rates have gone up as of recent, Trichet stated the move is a rational market reaction as a total of €244 billion in liquidity has been withdrawn from the markets during ECB refinance operations over the past two weeks. However, the liquidity reduction was bank-induced, as unlimited liquidity was offered by the ECB; as a result, the reduction should not be construed as a signal of tighter monetary policy (the €442 billion 12 month liquidity facility was replaced with a €132 billion 3 month and €111 billion 6 day facility, a €199 billion reduction; the following week, another €45 billion was withdrawn in the rolling of short-term facilities).

A good portion of the ECB press conference was dedicated to questions concerning the banking system. It shall be noted that this topic must have also been a central part of the deliberations as Olli Rehn, European Commissioner on Monetary and Economic Affairs, attended the ECB meeting. Since taking his position earlier this year, Mr. Rehn has taken an increasingly public profile in promoting and coordinating eurozone reforms and initiatives.

Little detail was given on the “stress tests” under way, except that Trichet emphasized that banks must improve their balance sheet by

* Retaining earnings;
* Raising capital in the markets;
* Taking advantage of government help where available and needed.

Rather than merely mentioning this plea in his prepared statement, as had become routine in recent months, Trichet emphasized the need for banks to take action multiple times during the Q&A.

Trichet brushed off criticisms the stress tests may be too benign, indicating the details are up to the local banking supervisors (although they coordinate with the ECB); the testing parameters and results would be published July 23, 2010.

We conclude Trichet sees improved bank capitalizations, rather than lower interest rates or quantitative easing, as key to lower interbank lending rates. Coercing banks to raise capital is the most positive potential implication of stress tests; such tests – in the U.S. and Europe alike – cannot possibly address all concerns in the markets.

As all too often, the public expects the ECB to have the solutions to all of the eurozone’s problems, but Trichet wisely – yet in the face of criticism – focuses on the big picture and forces governments and financial institutions to fulfill their duties in improving market conditions by pursuing necessary reforms. The good news is that the Spanish banking supervisors in particular are taking their work very seriously, even as both the tests and associated transparency are likely to fall short of demands in some eurozone countries.