Where Does the Money for European Countries' Loans Come From?

[Charles123]

Due to the credit crisis some European countries have asked for external help provided by a Troika constituted by the European Central Bank, International Monetary Fund and European Commission. In the loans that the Troika is giving to countries like Portugal, Ireland and Greece, where does the "money" come from? Is it only from funds of the IMF and the ECB, or it also comes from private banks and other lenders? In either case the countries are paying interest and spreads relative to the loans. This spread is destined to cover the loan service of those institutions, or it has other functions/destinations?
Also, and a different matter, how do central banks choose to which commercial banks they will lend money? What are the criteria that makes a bank suitable for a direct loan from the central bank? In the case of the Eurozone is the country to which the bank belongs considered in the criteria for choosing the eligible institutions to borrow money from the European Central Bank?

 

[John Creighto]

Also, and a different matter, how do central banks choose to which commercial banks they will lend money? What are the criteria that makes a bank suitable for a direct loan from the central bank? In the case of the Eurozone is the country to which the bank belongs considered in the criteria for choosing the eligible institutions to borrow money from the European Central Bank?

In Europe they have something similar to the discount window which would be available to banks which are sufficiently capitalized. As for measuring the capital I'm not sure if banks had to take any write-offs on Greek debts. I know private investers did. However, the quality of assets a bank holds should determine the percentage of those assets which are risk free and hence affect the capital ratios. Given each countries banks would have a different mix of assets in theory the central bank could set different criteria for different countries. However, it may be still the case where the banks are allowed to declare much of the sovern debt risk free.

The discount window is a mechinism to borrow over night from the central bank but it is a more expensive way to borrow then through the open market operations (or liquidity operations as they call them). The most controversial of these open market operations is the long term repurchase agreements. These are secured loans in that at the end of the term the borrower has to buy back the assets held as collateral by the central bank at an agreed upon price. In theory this gives the bank collateral if the borrower fails to pay and if the assets are good quality the risk is low.

I believe early on these RPO agreements used gold as collateral but more recently I believe that securitized sovereign debt was accepted to increase the liquidity of banks holding sovern debt.

http://www.istockanalyst.com/finance/story/5626549/securitization-of-eurozone-sovereign-debt-european-safe-bonds

The idea is that there is some maximum write off that sovereign debt is likely to take perhaps based on the debt to GDP. If the percentage debt writeoff in a defult is less then the percentage of debt which is held by Junior debt holders; then the Junior debt holders would take the losses while the senior debt holders would take none. However, because the senior debt is less risky then the Junior debt the interest rate paid on the debt is lower.

The central bank would hold the senior debt as collateral. The senior debt is called the first tranche or Tranche A. The market would determine the value of the Junior debt. The total borrowing cost to a country would depend on how much the market valued the Junior debt and the precentage of debt the bank would have to use as Junior debt to satisfy the central banks.

The controversial issue is the quality of the collateral held by the central bank which would depend upon if the Junior debt is large enough to absorb the likely risks. However, if the Junior tranche is too large then this will not help nations much in terms of borrowing costs.

All open market operations and discount operations can be viewed on the ECB website to see how much money liquidity the bank is injecting into the economy through these means.

 

[Charles123]

Thank you very much for your very clarifying answer! I need to read some things and before I ask you a follow-up question, that I certainly will.
If someone can add something about the criteria for the banks to use the "discount window", or on the spreads on the external help, It would be very much appreciated!
Regards