The Risks in ECB's Crisis Moves

WSJ: The European Central Bank's increasingly swollen balance sheet has helped bring a measure of calm to volatile markets, but some believe it could itself become a problem and bring more volatility to the 17-nation currency bloc.

Nearly a year of anticrisis-lending measures have sent the ECB's books to a record €2.73 trillion ($3.46 trillion), some 29% of the euro zone's gross domestic product, its highest percentage ever. This expansion, capturing both the collateral pledged by banks receiving funds from the central bank and the sovereign bonds that the bank has purchased for its own account, has been welcomed by bond investors, who see it as a stabilizing force in Europe's more-than-two-year-long debt saga.

But the excess liquidity and low interest rates the bank has set will clearly weigh on the euro's value. And the quality of the bonds and securities on hand are another point of concern. The risks to the ECB were heightened Friday, after Standard & Poor's stripped France and Austria of their triple-A credit ratings while downgrading other euro-zone members.

All of this has some market participants wondering if the ECB's own solvency could eventually be in peril.

David Beim, a finance professor at Columbia Business School in New York, recently wrote a paper warning that Europe's inability to get ahead of its debt troubles was jeopardizing the ECB's solvency. Prof. Beim thinks a large portion of the central bank's books could be at risk should Greece or other troubled countries be forced to default.

Yet exactly how exposed the ECB's financial position is to euro-zone contagion is a point of dispute. The central bank's securities holdings from outright purchases are large but relatively manageable. Of the ECB's estimated €211 billion in holdings of the weakest euro-zone nations' debt, only Greek debt—about 17% of that total—is seen as in the most immediate jeopardy.

Still, a solution to restructure Greece's mammoth debt load has proven elusive, and many investors are concerned that a default in the Hellenic republic could ricochet across the currency bloc. That could renew an assault on other euro-zone bond markets that are already distressed.

More worrisome are relaxed collateral rules. When the ECB introduced a three-year tender last month at generous 1% interest rates, more than 500 banks gorged themselves on a record €489 billion of the central bank's cash. Some analysts worry that a worsening of the weaker euro-zone bond markets could endanger securities pledged by the banks, posing a considerable solvency threat to the central bank.

"The quality of the balance sheet deteriorates as it expands, which is doubly problematic," said Michael Woolfolk, senior currency strategist at Bank of New York Mellon.

In addition to the asset-quality concerns, there is a weakening effect to the euro itself from interest-rate cuts and what Mr. Woolfolk says is a Federal Reserve-style "quantitative easing" program in all but name. "Any form of monetary easing is corrosive to the currency," Mr. Woolfolk said.

The U.S. central bank's balance sheet, currently standing at $2.9 trillion and at slightly more than 19% of U.S. economic output, is similar to the ECB's. But since the 2008 financial crisis, the Fed has put monetary policy on a far more aggressive path than its European counterpart, as the central bank slashed rates to near zero and undertook more than $1 trillion of bond buying that saw the Fed's balance sheet soar while flooding the U.S. with cash. Fed officials have hinted that a third round of quantitative easing may be needed to jump-start growth.

Defenders of the ECB say its primary form of monetary expansion can't be equated with quantitative easing. Unlike the Fed, the ECB isn't making large-scale bond purchases that permanently increase the money supply. By definition, its three-year refinancing operations are temporary, which doesn't leave excess liquidity sloshing around the financial system for long.

Yet over that period, the ECB will be sitting on securities that some observers believe to be of questionable quality. Should the central bank's balance sheet come under serious threat, the euro could also suffer the consequences.

Recent ECB rule changes expanded the type of debt banks can post as collateral—including, in some cases, noninvestment-grade bonds. Because the crisis has triggered a rout in bond markets and a rash of credit downgrades, some analysts worry that banks have unloaded poor-quality paper to the ECB, especially in the wake of December's record tender.

"There's obviously some question of whether or not enough [quality collateral] has been posted," said Aroop Chatterjee, chief quantitative strategist at Barclays Capital.

The ECB applies a "haircut" to the collateral it takes in—lending less than the security's face value—but it isn't clear if that method has protected its portfolio from deteriorating market values. Of special concern are its holdings of Greek debt, which have been hit especially hard during the crisis.

Marking the ECB's debt holdings to market value, Barclays estimates that its losses on Greek debt could be more than €25 billion. For now that is a modest sum, but it could get larger if there are write-downs from a forced restructuring or outright default. Barclays called the possible losses on ECB Spanish and Italian debt "relatively benign."

Furthermore, many observers believe that governments, knowing the importance of a solvent central bank, will help it out. Andrew Busch, global currency and public-policy strategist at BMO Capital Markets, said there "has to be some sort of tacit approval that the ECB will be made whole on losses from sovereign buys."

Although the central bank's bond purchases have become increasingly controversial, ECB policy makers have insisted that the central bank's burgeoning balance sheet doesn't put the institution at risk.

However, while that may be the official stance, former ECB member Jürgen Stark suggested there was some discord. In an interview with Germany's Die Welt newspaper in late December, Mr. Stark said the central bank's bond-buying was a factor that prompted his resignation.

By JAVIER E. DAVID