ECB backs effort to wean banks off central bank support

By Eva Kuehnen

FRANKFURT (Reuters) - The European Central Bank is encouraging market-led initiatives to make banks less dependent on its funding by making it easier for them to use loans as collateral in the interbank market.

Banks, especially in crisis-hit euro zone countries, are finding it increasingly difficult to come up with collateral to tap ECB loans due to tougher regulatory standards and downgrades in assets' ratings as a result of the financial crisis.

The problem is squeezing lending in the euro zone periphery, where banks charge businesses and households more than in the bloc's core countries. This means the ECB's single official interest rate is not transmitted evenly across the euro area.

ECB President Mario Draghi said last month enhancing the so-called "transmission mechanism" for its interest rates, which are at a record low, was the central bank's top priority.

Some officials are already warning of a collateral shortage.

"The crisis is making this collateral scarcer," ECB Executive Board member Yves Mersch told a conference on Tuesday.

To keep banks afloat the ECB has loosened standards on the securities it will accept, taking car loans, consumer finance and commercial mortgages with credit ratings just above 'junk'. But it would like to wean banks off its support eventually.

The ECB is looking at two proposals to free up more collateral that banks can use to fund themselves in the market rather than going to the central bank for financing.

At present, banks are able to use loans made to companies and households as collateral at the ECB but not with other banks. That is mainly because there is no harmonised system for evaluating loans and because legal systems and lending standards vary across the currency bloc.

At the end of last year, claims on such loans accounted for a quarter, or 656.5 billion euros (559 billion pounds), of the total collateral used at the ECB.

To make these assets useable as collateral in the market, one idea is to issue tradeable securities based on a bank's loan book that do not vary in quality and which could then be swapped for funding at other banks or at the central bank.

The other proposal would use a clearing system to transfer ownership of bank loans from one party to the other.

The ECB's money market contact group - a mix of around 20 top traders and a handful of top ECB experts - has discussed these proposals and concluded in a meeting summary published last week that the ECB encourages these market initiatives.

"The ECB has a strong interest in functioning money and capital markets to ensure (a) that it does not need to play an extensive interbank intermediation function, and (b) a smooth monetary policy transmission," the summary statement said.

"The Chairman noted that the ECB encourages these market initiatives aimed at mobilisation of collateral if these help to revitalise the interbank market and to facilitate refinancing of these assets in the market."

Being able to use loans as collateral not only at the central bank but also in the market would be another incentive for banks to increase lending to companies and households, which is drying up and holding back an economic recovery.

But a decision on which of the proposals will be applied is still quite a long way off.

David Hiscock, senior director at the International Capital Market Association, who works on market practice and regulatory policy, said it would be later this year at best, but more likely beyond than that.

"It also depends on the economic recovery and how quickly banks can be weaned off central bank support," he said.

"There isn't a deadline. But as long as the central bank provides support, the incentive to develop alternatives is reduced."

(Editing by Catherine Evans)