The European Central Bank is capping its weekly bond purchases at 20 billion euros and euro zone officials want banks to use its big new liquidity offer to buy more sovereign debt, ECB sources said on Friday.
The ECB has bought no more than 22 billion euros worth of bonds in any week since it reactivated its bond-buy program in August to defend Italy and Spain.
ECB sources said it would keep purchases to a maximum of 20 billion euros now and was not considering bigger action in response to an EU summit decision to create a fiscal union.
Europe secured an historic agreement to draft a new treaty for deeper economic integration in the euro zone but Britain, the region's third largest economy, refused to join the other 26 countries in a fiscal union and was left isolated.
We more or less anticipated what would come out, one ECB source said. We don't see any need for new deliberation.
The ECB bond-buy cap would remain at the level set weekly for the last few weeks by the Governing Council, a second source said. Weekly purchases have not topped 10 billion euros since September, less than half the limit.
You will see some further purchases but not the huge bazooka that some people in the markets and the media are awaiting, the second source said.
ECB President Mario Draghi had already dashed market expectations of increased bond buys in return for tougher budget rules a day earlier, when the central bank nonetheless agreed to boost its liquidity provision to banks.
At its monetary policy meeting on Thursday, the ECB offered ultra-long 3-year financing to banks and eased rules on the collateral it requires from them to tap its funds. It also cut its interest rates to a record low of 1.0 percent.
Euro zone leaders seized on the increased liquidity provision as a means to help fight the debt crisis, which has pushed up borrowing costs for countries on the periphery of the bloc - including G7 economy Italy - to unsustainable levels.
French President Nicolas Sarkozy said the ECB's increased provision of funds meant governments in countries like Italy and Spain could look to their countries' banks to buy their bonds.
This means that each state can turn to its banks, which will have liquidity at their disposal, Sarkozy told reporters at the summit in Brussels.
Markets were unconvinced that banks would start buying the bonds of peripheral euro zone countries as a result of increased ECB liquidity provision, however, and Italian bond yields rose on Friday, prompting the ECB to intervene in the market.
The notion that commercial banks could step up their purchases of government bonds looks optimistic given the same banks are being asked to deleverage and recapitalize if necessary after stress tests on the sector.
The lesson for banks from the stress tests was don't buy Italian bonds, said Berenberg bank economist Holger Schieding. Buying Italian bonds is probably the last thing banks will do with this extra liquidity.
Deutsche Bank economist Gilles Moec said the agreement on tighter fiscal rules could increase market confidence in the euro zone but he saw no mechanical link between the increased ECB liquidity provision and banks buying government bonds.
Draghi heightened expectations last week that the ECB could do more to fight the crisis by saying other elements might follow if governments agreed tighter budget controls first.
ECB watchers had taken that to mean the bank would step up its bond purchases but he firmly played down that interpretation on Thursday, instead insisting tighter fiscal rules were the best policy response to the crisis.
On leaving the EU summit in the early hours of Friday, Draghi said the meeting had laid a good basis for a new fiscal compact among the euro zone countries, although the details still needed to be sorted out in the days ahead.
NEW ECB ROLE
The ECB did emerge from the summit with a new role in fighting the crisis as it agreed to take charge of running market operations for the euro zone's EFSF and ESM bailout funds.
Although it will essentially just provide technical help, this move brings the ECB - a European institution markets respect - closer to the business of bailing out crisis-hit governments, without the central bank having to monetize debt.
ECB Governing Council Member Ignazio Visco said the decision should help bring down borrowing costs.
In testimony to the Italian parliament, the Bank of Italy chief said if bond yields come down as envisaged, the European Banking Authority had agreed it would reduce its upwardly revised capital requirements for banks announced on Thursday.
If this works, national bonds under attack will rise ... and EBA's decision can be reviewed and reduced, Visco said.
(Additional reporting by Julien Toyer, Gavin Jones and Paul Carrel; editing by Mike Peacock)