18 jump-start lending activity in the frozen term-funding market which is burdened with upcoming refinancing needs of sovereigns and banks. Participation (523 banks and 800 banks in the two operations, respectively) was encouraged by widening the eligible collateral and reducing reserve requirements. The dollar swap facility established by the ECB, along with other major central banks cutting the cost of their dollar swap lines, also helped improve dollar funding costs.

**21. As noted, the improvement in funding conditions is yet to materialize in actual credit developments.** Loans to the private sector by Euro Area banks continued to weaken in March 2012. Many banks are believed to have used the borrowed liquidity to retire debt to improve funding profiles and finance a profitable bond carry trade. With banks borrowing at 1 percent from the ECB and investing in high-yielding bonds, particularly peripheral government securities, the ECB effectively provided indirect support to sovereign bond markets.<sup>9</sup> The positive impact of sovereign bond purchases and improved bank funding conditions were reflected in rising bank equities and declining sovereign bond yields and bid-ask spreads. The supportive impact on lending, on the other hand, is expected to take time to unfold, in part reflecting weak demand for loans, weak economic prospects, and fragile investor and borrower confidence, given the continued tensions in the Euro Area, and in part continued deleveraging by banks and the private sector to reduce the indebtedness built up in the precrisis period.<sup>10</sup> Moreover, some peripheral banks are facing noticeable reductions in deposits, which could further inhibit private sector lending.<sup>11</sup>

**22. At the same time, subdued credit conditions also reflect continued worries that while the LTROs have bought time for banks and sovereigns, key underlying problems remain.** Market participants are concerned that reduced funding pressures due to ECB support may have diminished incentives to restructure balance sheets and to seek alternative, more sustainable ways to boost capital. Likewise, the LTROs can perpetuate unviable ―zombie‖ banks, which may continue to take risks. For governments, pressures to reform may have eased as borrowing costs decline. A flood of liquidity may also harbor the risk of bubbles in the bond, equity, and real estate markets. The encumbered LTRO collateral that banks put up has increased risk for senior bank bondholders, which might inhibit unsecured market funding going forward. Last, by loading up on sovereign bonds, banks have reversed a selling trend, realigning their fate

> 9 Most of the net €190 billion liquidity infusion of the first LTRO is believed to have been used by Spanish and Italian banks to purchase bonds with high yields. The larger LTRO in February (net ~€320 billion) is believed to have improved lending conditions, as more small banks participated and carry trade became slightly less attractive. Spanish banks bought €20.1 billion of government bonds in March (or €81 billion in the preceding four months), and Italian banks bought €24 billion of government debt (or €67 billion in the preceding four months), bringing Euro Area bank purchases to €142 billion in 2012:Q1. With most of the liquidity injection used by Italian and Spanish banks, the sovereign yield curves for Spain and Italy have decreased further, particularly on the short end. 10 Indeed, private credit conditions remained weak in February 2012, and only an estimated €10 billion of the December 2011 LTRO (5 percent) reportedly found its way to the real economy as credit.

> 11 The ECB data shows that Greek bank deposits fell from a peak of Є245 billion in end-2009 to Є170 billion in February 2012, while Spanish deposits fell by Є6.4 billion in February 2012, after a Є17 billion fall in January 2012.