European banks to soak up more ECB money

Mario Draghi, president of the European Central Bank, at a press conference earlier this month. The ECB is set to offer a second round of low-cost 3-year loans to European banks Wednesday.

NEW YORK (CNNMoney) -- After unleashing a wave of liquidity earlier this year, the European Central Bank is set to offer European banks another chance to soak up billions of euros in cheap loans.

On Wednesday, the ECB will announce the results of its second Long-Term Refinancing Operation, in which banks will be able to borrow money for 3-years at interest rates as low as 1%.

In December, the ECB allotted nearly €500 billion under the first round of the operation, which went to 523 banks in the eurozone.

Officially, the loans are part of the ECB's effort to prevent a credit crunch in Europe, where banks have been struggling to fund themselves since late last year amid concerns about exposure to bad sovereign debt.

But the program, along with other aggressive moves under ECB president Mario Draghi, has been widely credited with bringing down borrowing costs for Italy and Spain.

Since the first LTRO, yields on 10-year Italian bonds have dropped to about 5%, down from highs above 7% late last year. Spain's borrowing costs have also backed off last year's highs, holding near 5%.

Both nations have drawn strong demand at auctions of short-term bonds this year, easing fears of a full-blown debt contagion in the eurozone.

"It is likely that there will be further support for these bonds over the next month or so," said Garry Jenkins, a credit analyst at Swordfish Research.

Money market funds dip back into eurozone debt

The improvement has allowed the ECB to scale back its purchases of government debt under its controversial securities market program.

Investors say the ECB has helped restore confidence in global financial markets by mitigating the risk of a banking crisis and creating some breathing room for euro area governments. But there are questions about how the market will respond to the second round of LTRO financing.

"The ECB's decisive action has helped to stabilize demand for Spanish and Italian bonds, and the 3-year tender will free further cash," said Kim Rupert, a fixed-income analyst at Action Economics. "But it remains to be seen whether the cash will find its way to the bond market."

Banks are under no obligation to use ECB loans to buy government bonds. Given the heavy refinancing needs and more stringent capital requirements European banks are facing this year, many may be tempted to stockpile the cash.

"It will be interesting to see how markets develop and auctions fare after the 3-year tender is out of the way," said Rupert.

In the meantime, the big question is how much money will banks borrow Wednesday?

Estimates have ranged from €300 billion to €500 billion, though some analysts have said banks could take up to €1 trillion.

The estimates reflect expectations that more non-euro area banks will participate, along with automakers and other corporations that can access ECB funds as "monetary financial institutions."

"No one can have a good idea of the demand for cash at this operation, although optimism seems to reign supreme," said Carl Weinberg, chief economist at High Frequency Economics.

Yet some analysts say banks might be reluctant to borrow too much in order to avoid the "stigma" of appearing strapped for cash.

"There is a question whether strong participation will be viewed as signaling increased willingness to buy risky assets, or as a sign of funding weakness," said Steven Englander, currency strategist at CitiFX, in a note to clients.

G20 chiefs: Europe needs a bigger financial firewall

Englander estimates that €600 billion would be "an unambiguous positive surprise," but he warned that if banks borrow less than €300 billion "there could be a bit of a scramble in markets until it becomes clear what drove the lack of participation."

Beyond the immediate market reaction, there are questions about how effective the program will be in resolving the underlying causes of the debt crisis in the eurozone.

Draghi has said the ECB's goal is to support the banking sector and boost lending to the "real economy." He has stressed that the ECB is legally prohibited from supporting government finances and that the onus is on policy makers to reign in spending.

Guy Mandy, fixed income analyst at Nomura Securities, said in a research report that the LTRO has reduced the possibility of a bank failure due to a liquidity crisis.

But he suggested that a more lasting solution to the debt crisis would involve the ECB committing to buy government bonds directly from banks, a monetary strategy known as quantitative easing.

"We think this is a temporary solution to the inability of banks to access unsecured financing and as such has only indirect lasting benefit for the underlying eurozone debt crisis," Mandy said.