FUNDING:THE EUROPEAN Central Bank stepped up its response to the euro zone crisis by providing €489 billion in unprecedented three-year loans to more than 500 banks across the region.

The stronger-than-expected demand, a record for the amount allocated in a single ECB liquidity operation, came after banks were urged by policymakers to take the funds as part of a concerted effort to ease strains in the financial system.

The offer of unlimited three- year loans, announced this month, comes ahead of a crucial first quarter of 2012 for the euro zone when a large volume of bank and government debt is due for refinancing.

The outcome was initially cheered by markets, with the euro and equities surging on hopes it would help ease banks’ stretched balance sheets, but enthusiasm waned.

Sebastien Galy, senior currency strategist at Société Générale, said the operation had provided “a sugar-rush” in financing support for banks.

But it “does not, of course, resolve the deep-seated issues facing Europe”.

Markets have been debating whether the banks will use the cheap loans to buy higher yielding government debt in a classic “carry trade” rather than finance existing assets. Banks used about half the €442 billion allocated in one-year loans in June 2009 to buy higher-yielding sovereign debt, mostly Greek and Spanish government bonds.

The ECB has sought to reduce banks’ funding difficulties in the hope of averting a dangerous “credit crunch” that would drive the euro zone into a deep recession. However, some ECB policymakers have gone further, urging banks to use the funds to support struggling euro zone government bond markets.

The ECB gave no details but analysts said demand for the loans was likely to have been heaviest from the peripheral countries.

In Madrid, bankers said take-up by Spanish banks was likely to have been substantial.

“If everyone does it, the stigma goes away,” said one, referring to the reputational risks associated with accessing ECB liquidity.

One Spanish bank director described the use of central bank financing to buy government debt as “natural and normal”.

“If the sovereigns go down, then so do the commercial banks . . . so they are really defending their own interests.”

French banks were encouraged by the Bank of France to take advantage of the new ECB facility.

BNP Paribas, France’s largest bank, was understood to be taking part, although it and its main rival Société Générale declined to comment. – (Copyright The Financial Times Limited 2011)