The Brexit vote has sunk bank shares, weakened the euro and will lower growth, raising market pressure on the ECB to step in, adding more stimulus.
But conversations and public comments from over a dozen officials familiar with the ECB's thinking showed that the bank has found some reassurance in the market rebound this week and was happy to take a wait-and-see stance, given the lack of hard evidence about the actual impact of Brexit.
Indeed, ECB Vice President Vitor Constancio said that markets were already rebounding, banks suffered no liquidity shortage and economic fundamentals were broadly unchanged, so the ECB needed to wait to assess if any response was needed.
Emergency swap lines designed to provide euros to UK banks in case of stress had not been activated and the market turmoil reflects lower growth prospects, not panic, other ECB sources, who asked not to be named, said.
"This is a political problem not a monetary phenomenon," one of the sources said. "We could act, we have the tools, but that would not solve the broader problem and for now, every estimate about the actual impact of Brexit is nothing but guesswork."
If markets continued in the same, calm vein in the run up to the ECB's July 21 policy meeting, the most to expect could be verbal reassurance that the bank stands ready to do more if needed, the officials said.
But a more severe economic downturn would not be for the ECB to handle, requiring others to step in, Constancio warned.
"In monetary policy, we still have instruments," Constancio said. "But it’s true that we have been using a lot of those instruments, we are aware and everyone is aware of that."
"So, if the consequences would be more severe in economic terms what could be done, if anything? But it’s with other authorities, it’s not then with the ECB," he added.
RELIEF
For now, the officials expressed relief at the sanguine reaction of investors in sovereign debt. Southern Europe's borrowing costs fell sharply for a third straight day and French bond yields hit record lows on Wednesday. [GVD/EUR]
The calm on the sovereign bond market marked a sharp contrast to the 2010-12 debt crisis, when a 'doom loop' between indebted governments and their main creditors, banks, threatened the euro's very existence, the sources noted.
"Markets priced in a lower growth path, both for the euro zone and the UK," one source said. "It seems quite realistic now and I don't see significant overreaction."
Still, this line of thinking may put the ECB on a collision course with markets, which have rebounded at least partly in the hope that the ECB and the Bank of England would step in with more stimulus.
Investors now fully price in a rate cut in Britain and the euro zone by the end of this year.
The ECB cut rates twice since December and is already buying 80 billion euros (65.60 billion pound) worth of assets, mainly euro zone government bonds, every month in a bid to boost inflation.
These purchases helped soothe market nerves when a Greek referendum on the terms of its bailout agreement with creditors almost pushed the country out of the euro zone last summer and the reaction to the UK vote was seemingly following the same path.
The sources said that any further move by the ECB to support markets, while possible in theory, would merely act as stop-gap and do nothing to address fundamental citizen and investor concern about Europe's political cohesion and economic strategy.
BANKS
In fact, a new interest rate cut could even exacerbate problems at euro zone banks, which have complained that low lending rates and a charge on the money they park at the ECB were squeezing their margins, some of the sources said.
There was agreement among the officials who spoke to Reuters that the broad selloff in banking shares cast the sector as the weakest link in the European economy, with its meagre profits and, in countries such as Italy, heavy burden of bad loans making it vulnerable to any economic downturn.
The ECB's top supervisor, Daniele Nouy, spelled out some of the steps the ECB would like European and national law-makers to take in a letter to a group of members of the European parliament published on Tuesday.
"Among other reforms, they should consider streamlining legal processes related to debt recovery, removing impediments to the enforcement of loan collateral, introducing out-of-court debt work-out solutions, and fostering the development of distressed debt markets," Nouy wrote.
(Editing by Jeremy Gaunt)
By Francesco Canepa and Balazs Koranyi
