The ECB, like the Federal Reserve, implemented bank liquidity facilities which (in oversimplified terms) allow them to pledge collateral in exchange for cash. The ECB has been more liberal in the types of collateral that it accepts, which has led to some pretty blatant gaming of the system (and God only knows how much slippery behavior at the margin).

The ECB decided it had had enough, and "refined" its rules a tad, airly noting it shouldn't affect much collatal. The markets took a rather different view and banking stocks beat a hasty retreat, even though the changes do no come into effect until February 1 (not surprisingly, after the widely-anticipated year-end liquidity squeeze).

From the Financial Times (hat tip reader Marshall):

Bank stocks in Europe and the UK fell sharply and the risk of owning their debt leapt on Thursday after the European Central Bank declared a crackdown on abuses of its bank liquidity operations.....

Mr Trichet announced a series of measures to increase the cost of using asset-backed securities to obtain ECB funds and to exclude some such deals when underlying mortgages or other loans are not denominated in euros...

This year it emerged Macquarie Bank had constructed a deal backed by Australian car loans that could be used at the ECB and Lehman Brothers had formed a huge collateralised loan obligation of risky buy-out debt to use at the central bank.

Mr Trichet said the ?general character? of its broad-based operations remained unaffected. ?We?re not changing it, we?re refining it,? he said.

Only a ?small fraction? of collateral would be affected. Banks? ability to take part in its financing operations would be unimpaired, the ECB president said.

Analysts said the changes would affect banks sharply. ?[It is] a further squeeze on banks, increasing the pressure on them to do more expensive longer-term funding ... when there is already investor concern about ... their existing refinancing needs,? said Matt King, credit strategist at Citigroup.

UK banks saw the biggest share falls with HBOS down almost 7 per cent at 282.5p, Barclays down 6 per cent at 336.96p and Lloyds TSB down 5.7 per cent at 288.9p. The worst-affected European banks were UBS of Switzerland and some smaller regional banks such as Erste Group of Austria and Piraeus Bank of Greece....

The changes, which take effect from February 1, include increases in the average ?haircuts? applied to asset-backed securities. A haircut is the amount deducted from the market value of a product when judging its value as collateral. In future, a blanket 12 per cent haircut will apply, replacing a previous sliding scale of between 2 per cent and 18 per cent. There will be penalties for asset-backed securities valued using models and for unsecured bank bonds.

Restrictions already in place on banks using assets they themselves had formed were extended to stop banks using assets from issues to which they had offered currency hedges or liquidity support above a certain level.

Analysts at Barclays Capital said the extra haircuts would mean banks might have to post an additional ?25bn-?45bn of securities for collateral purposes. ?That could cost ?375m to ?450m annually to banks ... Not in significant, but probably bearable,? said Laurent Fransolet, analyst at Barcap.

Update 12:30 AM: Willem Buiter provides a detailed discussion. His conclusion:

Two things are clear. First, much more will have to be done to clean out the Augean stables of the EU collateral universe. Second, nothing serious will happen until the current financial crisis is history. Stable-cleaning measures will tighten credit and worsen liquidity conditions in unpredictable ways. Now may not be the right time for a great leap forward towards the first-best. Even the minor tinkering measures announced on September 4 won?t become effective until February 1, 2009. So go for it, boys and girls. Repo your rubbish while you may!