Unsurprisingly given Bundesbank opposition and the constraints imposed by its mandate, the ECB last week refrained from launching large-scale country-neutral QE, as warranted by Eurozone-wide monetary weakness and an oncoming recession.

This refusal, however, was counterbalanced by an unexpectedly generous expansion of its banking system support operations, with an increase in the maximum term of subsidised lending to three years accompanied by a significant further loosening of collateral requirements. Sig. Draghi hopes that a massive infusion of cash will discourage banks from liquidating their sovereign bond portfolios and even stimulate renewed purchases, thereby achieving QE by the back door.

This strategy seems to have been successfully employed in 2008-09 – the ECB’s repo lending rose by €350 billion in October 2008, following Lehman’s collapse, while bank purchases of government bonds surged to €315 billion over the subsequent 12 months. The latter amount was the equivalent of 3.4% of the M3 money supply.

Recent losses, heightened default risk and new mark to market requirements suggest that banks will be much more circumspect about expanding their bond portfolios now. The current infusion of liquidity, however, may surpass the 2008-09 increase by a wide margin as banks make full use of the subsidised three-year operations next week and in February. The interest reward for accepting sovereign risk, moreover, is much greater than post Lehman – the spread between the Italian 10-year yield and the ECB’s repo rate was 260 basis points in January 2009 versus a recent peak of 600.

The backdoor QE ploy is sub-optimal and risky but was Sig. Draghi’s best available option and may yet succeed in loosening monetary conditions and limiting the current recession.