The European Central Bank may be making it harder for theregion's banks to revive bond sales by giving them access tounlimited cheap cash.

Issuance of senior unsecured euro debt by banks fell about 35percent to 51.4 billion euros ($67 billion) in the six months endedFeb. 6 from the same period a year earlier, data compiled byBloomberg show. The average relative yield on the debt is 307 basispoints, up from about 200 before the region's sovereign debt crisisworsened in June, according to Bank of America Merrill Lynch's EURCorporates, Banking index.

The ECB pumped 489 billion euros into the banking system inDecember through the so-called longer-term refinancing operation tohead off a potential credit crunch. The central bank is planninganother injection of three-year loans on Feb. 28. Participation bylenders may total a further 1 trillion euros, according to MarchelAlexandrovich, an economist at Jefferies International Ltd. inLondon.

“The LTRO isn't so much a backstop for the banks, it's more of afront-stop,” said Jonathan Cooper, a senior consultant at Finadium,a Concord, Massachusetts-based research and consulting firm. “Threeyears is a long time and the risk is that the banks will be prettyaddicted by the time it ends.”

Unsecured debt is becoming less attractive to investors becausebanks are having to pledge more assets as collateral for ECB loans.An increase in issuance of covered bonds, notes secured onmortgages or public-sector loans and guaranteed by the issuer, isalso depleting the collateral pool.

Benchmark issuance of covered bonds in the single currency was93.7 billion euros — almost double the sales of senior unsecureddebt — in the six months through Feb. 6, after reaching 127 billioneuros a year earlier, Bloomberg data show.

There are about 2.6 trillion euros of the securitiesoutstanding, backed by about 3.5 trillion euros of prime bankingassets, according to estimates by Jonathan Glionna, an analyst atBarclays Capital in London. Assets used as collateral for centralbank borrowings bring the total unavailable to unsecured creditorsin a default to about 4.5 trillion euros, he said.

“By putting on a lot of secured funding, you subordinateeveryone else and in the end you make it harder to issue seniorunsecured bonds,” said Roger Doig, an analyst at London-basedSchroders Plc, which manages about $58 billion in fixed-incomeassets. “The ECB is between a rock and a hard place. If the LTROmoney wasn't available, banks would be starting to fail.”

Taxpayer Bailouts

Governments racing to adjust the rules to favor depositors andreduce or eliminate the role of taxpayers in bailing out distressedlenders aren't helping. The changes will lower potential recoveriesfor unsecured creditors in a default, probably to zero, accordingto Glionna at Barclays Capital.

That means holders of senior unsecured debt will be pushedfurther down the pecking order should a bank fail, resulting in anarrowing of the yield difference between senior and subordinatedbonds, he said.

The difference in the cost of insuring banks' senior andsubordinated bonds against default using indexes of credit-defaultswaps has shrunk to 137 basis points, the lowest since August,according to CMA. The spread between the two gauges reached arecord high of 256 basis points on Nov. 25.

Swaps pay the buyer face value in exchange for the underlyingsecurities or the cash equivalent should a borrower fail to adhereto its debt agreements.

The spread in average yield between the two types of securitiesin the cash market is 364 basis points, matching the level at theend of October, Bank of America Merrill Lynch index data show. Thedifference was 481 basis points, the most since May 2009, on Dec.31.

“Banks are pledging more and more of their assets to the ECB andto covered bond buyers,” said John Raymond, an analyst atCreditSights Inc. in London. “For senior unsecured bondholders, itall adds up to structural subordination.”

More assets will be removed from bank balance sheets in the nextLTRO, after the ECB said it will accept bank loans as collateralfor their borrowing.

“Asset encumbrance is already a big deal in certainjurisdictions,” said Paul Smillie, who helps oversee about $43billion of fixed income as an analyst at Threadneedle AssetManagement in London. “Claims of unsecured creditors are beingpushed way down the line.”

Unsecured funding is vital to banks because of the flexibilityit offers and because lenders' business models are based oncharging borrowers a higher rate than they themselves pay toborrow, according to James Ferguson, chief strategist at WesthouseSecurities in London.

“Senior unsecured borrowings more closely reflect the maturitiesof bank assets,” he said. “If banks can't raise private-sectorfunding at acceptable prices, the central bank has to step in.”

Bloomberg News

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