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European Banks Head Down a Dangerous Path as they Turn to the ECB for Funding

Everyone is happy that bond yields are falling, but what is the next step in the resolution of the crisis?  Here is one report from the front, decide for yourself whether it is good or bad news:

Last week 800 banks requested €529.5bn of three-year funding under the European Central Bank’s longer-term refinancing operation, on top of €489bn borrowed in the first tranche of the LTRO in December.

The €1.019tn total is not far shy of the €1.106tn of European bank senior debt due to mature in 2012, 2013 and 2014 combined, according to Goldman Sachs, which said the “extremely high” injection of capital means “European banks are now effectively pre-funded through to 2014”.

Given that the ECB funding costs 1 per cent, compared to yields on senior debt of 3.5 per cent, some believe many banks will simply let much of their senior debt mature…

It would be an exaggeration to claim that the ECB has taken over European capital markets for three years, but you can see where my thoughts are headed.  What happens when the three years is up, or as that time approaches?  I see a few possible scenarios:
1. Banks recapitalize themselves with sound lending, and at the end of the three years they return to private capital markets by issuing debt.  What would the new cost of capital be?

2. European banks continue to hover on the precipice for three years, and as expiration approaches the ECB renews its commitment to fund.  (If the ECB funds the banks for six years running, at what point are the banks de facto nationalized?  After how many years of ECB funding at one percent is it impossible to return to private markets?)

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