Shoddy collateral labeled “ECB-eligible” is a great deal for banks.

By Don Quijones, Spain & Mexico, editor at WOLF STREET

Since the financial sectors of Southern Europe and Ireland hit the rocks during the height of Europe’s sovereign debt crisis, many of their respective banks have grown dependent on the generosity of the ECB – a generosity that, as Greece recently learned to its great cost, has its limits.

In the last three years, the banks of Europe’s biggest bailed out economy, Spain, have received ultra-low interest loans from the ECB worth some €140 billion. To obtain that liquidity, the banks are required by law to deposit collateral with the ECB. However, Germany’s leading business and financial newspaper Handelsblatt now reveals that some Spanish banks have received special treatment from Spain’s central bank, the Banco de España, some of whose officials have shown no qualms about bending the rules:

Handelsblatt has learned that the Spanish central bank repeatedly stretched the ECB rules recently. It approved securities as collateral that were not sufficiently creditworthy. In addition, other bonds were “ECB-eligible,” but the discount on those bonds should have been higher than it was and the amount of money received in return lower.

This Spanish laissez-faire attitude has consequences for the rest of Europe. On the one hand, it exposes the ECB to the risk of being left with low-quality securities in the event of a bank failure. This would ultimately become a burden for European taxpayers.

On the other hand, it is advantageous for banks if their securities are unjustifiably classified as “ECB-eligible,” because such bonds are easier to sell and at good prices.

A staggering 32,000 securities are currently registered as collateral by the ECB, which makes you wonder what it might actually take for a financial instrument not to be accepted as collateral these days. Indeed, even when a bank’s asset is beyond the pale, it can still make the grade, thanks to a little creative risk-assessment by a national central bank.

Whenever central bankers make this kind of (no doubt) honest mistake, it effectively gives the bank in question a very convenient, undeclared subsidy. The more shady bonds a central bank approves as collateral, the more money their issuers can potentially borrow. And when it comes to manufacturing shady bonds, Europe is quite literally in a league of its own.

Pulling the Wool Over The ECB’s Eyes

One direct beneficiary of the Bank of Spain’s lax fiduciary standards is the Catalonia-based Banco de Sabadell, which attracted international attention earlier this year by acquiring British bank TSB from Lloyds. According to Handelsblatt, Sabadell had 72 short-term bonds on the ECB list whose ratings were not good enough for the “ECB-eligible” seal of approval. After being notified, the ECB immediately removed those bonds, worth €395 million, from its list of safe securities.

It is not the first time, however, that so-called “strays” have found their way onto the securities list:

The ECB removed €728 million in short-term bonds issued by other Spanish banks from its list earlier this year… Three years ago, several cases in Ireland were made public in which the Irish central bank had provided bonds with discounts that were too low. The governments in Spain and Italy also guaranteed a substantial volume of bonds issued by domestic banks, which were then able to submit the securities to the ECB at favorable terms.

All of which begs the question: how are national central banks like Banco de España able to pull the wool over the ECB’s eyes with such apparent ease? According to Helmut Siekmann, a professor at the University of Frankfurt, it’s all a question of time, manpower and efficiency. “The ECB originally had too little personnel to handle all of its operational tasks, such as verifying securities’ central-bank eligibility on its own,” he says.

In the face of often protracted inspections, the Frankfurt-based central bank has little choice but to outsource a large part of the verification process to national central banks, which must examine each bond for eligibility, according to a very long official list – one which allegedly is full of mistakes. The national central bank then informs the ECB about the collateral’s suitability.

This saves the ECB from having to write to the rating agencies and the banks, all of which takes an inordinate amount of time, not to mention a lot of paper. By contrast, the Spanish central bank can get the job done much more quickly, with the Spaniards “managing to examine and classify the securities of domestic banks within a day.”

Now that is what you call efficiency! Who cares if a few honest mistakes are made along the way! By Don Quijones, Raging Bull-Shit.

Are we surprised yet? Because the police is now investigating Spain’s financial regulator over allegations of forgery, bribery, extortion, money laundering, and involvement in organized crime. It can hardly get any better. Read… Extortion Inc: Spain’s Financial Regulator in the Hot Seat

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