The ECB has taken drastic measures to ensure the liquidity, and probably more realistically, the solvency of the European banking system. Through long-term refinancing options, which are essentially near costless loans, the ECB has tried to kick start banks into lending mode.
However, as apparent in this Financial Times analysis video, these actions have failed to inspire confidence in the banking system. Despite obtaining over $600 billion from ECB loans, banks would rather build up cash reserves and park it at the ECB for chump change than lend it out and face the risk of no repayment. In turn, businesses can’t receive the necessary capital to engage in investment or properly carry on operations, thus negatively impacting the real economy.
Outside of the Eurozone’s poor public finances, Europe’s banks are the engine that will determine whether Europe’s financial system will run effectively. Insolvency is such a significant fear that banks are pursuing an ultra low risk strategy where they don’t even want to purchase government debt.
This leaves the ECB to foot the bill and take on dangerous exposure to countries with high borrowing costs such as Italy and Spain. In essence, the risk simply gets shoved to the ECB, putting Europe in greater danger if the ECB’s balance sheet starts becoming toxic, which would then trickle down to Europe’s biggest banks.
Although markets may not be hurting badly right now, a deepening of Europe’s banking crisis can rapidly change that.