The fact of the matter is that European bank funding markets are collapsing onto the ECB balance sheet. Forget about the €200 billion of outright peripheral bond purchases--small potatoes. National central bank exposures, through the TARGET clearing system, now exceed €400 billion, and private bank exposures, through discount lending and deposit facilities, are the same order of magnitude.
Apparently everybody, borrowers and lenders, public and private, wants the ECB as their counterparty. Reluctant though the ECB may be to step into that role, and vocal as the ECB has been about that reluctance, what we are seeing in practice is that it has no choice, literally.
Clearing imbalances within the Eurozone that cannot be resolved in the interbank market show up mechanically as imbalances between national central banks on the books of the ECB (see here for details). The ECB lends to the central bank of the deficit country and borrows from the central bank of the surplus country, so expanding its own balance sheet on both sides. (Think Greece on the asset side, and Germany on the liability side.)
Something quite similar happens when private banks settle private clearing imbalances not by shifting reserves from deficit to surplus but rather by the deficit bank borrowing from the ECB and the surplus bank lending. Again, the ECB balance sheet expands on both sides.
Why is this happening?
The underlying problem is that deficit central banks and deficit private banks increasingly have nothing to sell (or to pledge) that surplus central banks and surplus private banks want to buy (or accept as collateral for a loan). The ECB is also reluctant to buy--it is serving as pawnbroker of last resort, not dealer of last resort.
The consequence is that the ECB is more or less forced to lend, against more or less whatever collateral is offered; even bad collateral is better than no collateral. (The famous Bagehot Principle offers an out, since it urges valuation of collateral at non-stress prices.)
Now comes the latest deal over eurozone fiscal rules, presumably the deal that ECB President Draghi asked for last week. It is a deal about sovereign budget discipline. But if I read Draghi's speech right, we should not expect him to be buying sovereign debt. (That will be the IMF's job, if anyone's, and with strict conditionality; details to be sorted later.)
Instead, he'll be buying bank debt, specifically the debt of the banks that hold the sovereign debt. Banks currently borrowing from their own national central banks will therefore be able to repay, and consequently the national central banks will be able to repay the ECB. This takes national central banks out of the picture on the asset side.
What about the liability side? Here, perhaps in a longer time frame, I think the logical move is again to take the national central bank out of the equation, by replacing liabilities to the Bundesbank with deposits to the credit of private banks. Freed from the responsibility to fund ECB loans to other central banks, the Bundesbank will be able to return to its preferred asset holding, German sovereign bonds.
Bottom line, we're not going to be using the payment system to hide imbalances any more. The ECB is going to serve as a proper lender of last resort to the banking system, affirmatively and up front rather than mechanically and through the back door. But it will be doing so only to the banking system, not to sovereign debtors. It is a first step, taken only because hiding imbalances in the payments system was beginning to cause problems in the payment system, but it is the right step and opens the door to more.