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European Interbank Markets Stress Rises Over Counterparty Fears

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It’s starting to fell like 2007 and 2008 all over again: banks suddenly cautious about lending to each other, with the stress spilling into other markets. Per Bloomberg:

The cost to hedge against losses on European bank bonds is 63 percent higher than a month earlier. Investment-grade corporate debt sales in the region plummeted 88 percent last week to $1.2 billion from the prior period…

The rate banks say they charge each other for three-month loans in dollars is the highest in nine months…

The three-month London interbank offered rate in dollars, or Libor, rose to 0.445 percent last week, the highest level since August, from 0.428 percent on May 7 and 0.252 at the end of February…

Concerns have spilled into the market for commercial paper, debt used by companies and banks for their short-term operating needs. Rates on 90-day paper are more than double the upper band of the federal funds rate, about twice the average in the five years before credit markets seized up in mid-2007.

“The list of banks able to tap the three-month market remains extremely limited with access spotty and expensive,” Joseph Abate, a money-market strategist at Barclays in New York, wrote in a May 14 note to clients…..

Rates on commercial paper for 90 days are 24 basis points above the upper band of the Fed’s zero to 25-basis point target rate for overnight loans among banks. While far below the 245- basis point gap reached in October 2008, the spread is more than double the 10-basis-point average in the five years before credit markets seized up in the middle of 2007. As recently as February, financial CP rates were below the federal funds rate.

Except for banks with little exposure to European sovereign risk, banks “have found liquidity to be scarce, securing funding only one month and shorter and mostly concentrated inside one week,” Abate from Barclays wrote in the report.

Yves here. The Bloomberg piece highlights Royal Bank of Scotland and Barclays as the banks hit with the biggest rise in funding costs.

Where this all gets a bit nasty is the worries re MTM losses, not just on sovereign debt, but on other risky assets as well (and don’t underestimate the ability of a bank to have wrongfooted their currency exposures). Remember, most observers believe banks generally, and UK/European banks in particular, have not recognized the full extent of their losses from the last crisis (cheap liquidity has enabled a lot of dubious assets to be marked at levels that are questionable given their long-term prospects).

While all eyes have been on the plummeting euro, sterling hasn’t fared too well either, and a lot of my UK contacts expect it to be decline (the powers that be presumably hope that Mr. Market will take care of that, but they think a formal devaluation is not out of the cards). But the open question is whether a desired slide in the value of the pound could morph into a currency crisis. As Willem Buiter warned in 2009:

The risk of a triple crisis – a banking crisis, a currency crisis and a sovereign debt default crisis – is always there for countries that are afflicted with the inconsistent quartet identified by Anne Sibert and myself in our work on Iceland: (1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity.

The argument is simple. First consider the case where the banking sector is fundamentally solvent, in the sense that its assets, if held to maturity, would cover its liabilities…There is no such thing as a safe bank, even if the bank is sound. Without an explicit or implicit government guarantee, there is always the risk of a bank run (a withdrawal of deposits or a refusal to renew maturing credit and to roll over maturing debt) or a sudden market seizure or ’strike’ in the markets for the bank’s assets bringing down a fundamentally sound bank.

To prevent a fundamentally sound bank succumbing to a deposit run or to asset market illiquidity, the central bank has to be able to act as lender of last resort, providing funding liquidity and as market maker of last resort, providing market liquidity to liquidity-constrained banks…

The UK banking sector’s balance sheet is about half the size of the Icelandic banking sector as a share of annual GDP: just under 450% at the end of 2007 as compared to Iceland’s almost 900%…. If we exclude the Bank of England, the latest observation on the balance sheet of the banking sector and a percentage of annual GDP would still be around 420 percent. The deleveraging of the banking sector, visible at the very end of the sample period, has much further to go…..foreign currency assets and liabilities of the banking sector are very evenly matched….

While there is no net foreign exchange exposure of the banking system in the UK, banks are banks. The foreign currency liabilities of the banking system are therefore likely to have shorter maturities than the foreign currency assets. The foreign currency assets are also likely to be less liquid than the liabilities….With foreign currency assets of longer maturity and less liquid than foreign liabilities, the banks and the country would still be vulnerable to a foreign currency run on the banks (a refusal to renew foreign currency credit) or a seizing up of the markets in which the banks’ foreign currency assets are traded. The Bank of England’s foreign currency reserves are puny and the government’s foreign currency reserves are small – around US$43 billion, pocket change, really.

Yves here. You can see where this is going…the UK cannot credibly backstop its banks if they have trouble rolling their short term foreign currency borrowings. Not a pretty line of thought.

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24 comments

    1. NotTimothyGeithner

      In 2007, there were 1,121,516,000 nominal Catholics in the world. The state of the Catholic Church is always a serious matter with that kind of population. Maybe Yves hit a little too close to home for your comfort?

  1. dedalus

    nice timing with this post:

    the GBP/USD just hit a new low a few minutes ago. It’s down almost 150 pips on the night. And London doesn’t open for another 3 hours yet. The Nikkei is down almost 2%.

    It could get ugly tomorrow.

  2. Chicken Little

    I love NakedCapitalism. My friends think it is a porn site, but oh well, human behavior.

    Sites like ZeroHedge, are so DoomsDay, that gets quickly.

    Yves has done an excellent job, with fair and realistic reporting, and views of the world and markets.

    Jesses Cafe Americana is another excellent blog. Great charts and comments.

    Asia is down hard. Bonds up strong. Gold holding. If everyone runs for the exit at the same time, it could get ugly.

    CNBC will tell you, time to buy on the dips. Obama will tell you, he is looking into the problem. TurboTax Timmy, will reassure you, everything is okay.

    Scary times we live in. Nothing new, life has its ups and downs.

    When debt investors realize, the debts might never be repaid, thats when the fun begins. How will China react, when we pay China back with Dollars worth HALF of what they use to be worth ?

    Then bond buyers try to sell bonds, the markets will make history. Strap on your seat belts, this is going to be a wild ride.

    1. K Ackermann

      Knowing ZeroHedge is shrill makes them easier to read. They are in front of some good stories now and again.

      I still like Mish, but he’s getting too religious.

      A great site to peek at during the day is Some Assembly Required. He has 8 or 10 interesting links to economics and news stories every day, but his comments are great. A very effective use of humor and soft sarcasm to highlight the absurd.

      I agree about Jesse. Very intelligent commentary.

      Right here is my favorite.

  3. alex black

    Excellent post, and as usual, great insight from Buiter. The scary part is, ever since Buiter joined Citi, his writing has become…. understated. I suspect that if he was just writing on his own, he would be howling from the rafters about this.

    It’s almost like, if you were a little kid and your dad came in to tell you there is a monster in your closet, you would be frightened if he was shouting, but you’d have cause to be even more frightened if he was telling you this while intentionally lowering his tone of voice….

    Pound now down 210…..

    1. bob goodwin

      On Buiters goodby post, he said he would be far more reserved as a Citi employee than as a pure academic. It is part and parcel with the paycheck.

  4. Ignim Brites

    Buiter neglects to point out that banks could match maturities. Of course, they would make a lot less money.

    1. ndk

      Still doesn’t help with actual credit losses, of which there could be a lot.

      I’m curious to see whether the U.K. would try to use anti-terrorism laws on itself. :D

  5. ndk

    I see that I have to refute this again.

    Except for banks with little exposure to European sovereign risk, banks “have found liquidity to be scarce, securing funding only one month and shorter and mostly concentrated inside one week,” Abate from Barclays wrote in the report.

    It’s not illiquidity. It’s insolvency. I would hope that the persistence of these problems for going on 3 years now would have made that abundantly clear to everybody involved, but apparently it hasn’t.

    Bailouts do not prevent contagion. Bailouts cause contagion. Previously good credits debauch their balance sheets trying to save other credits.

    Governments can’t possibly run a large enough deficit for long enough to cover the sins of the private sector over the last umpteen years — and even if they could, we end up only with more total credit to GDP and more instability.

    Let the debt default.

    1. K Ackermann

      Exactly. They had the problem confined to Greece, but to spare a haircut for bondholders… I mean to prevent the sun from exploding, they just had to infect the rest of the EU.

      It is the mechanism of choice to socialize private losses. It is exactly theft, and it is proving to be so successful, that theft is now an investment strategy at a global scale.

      The theft is outpacing the laws. Laws are designed to keep transactions zero-sum. When they are not, then an imbalance manifests, and that undoes the system.

      Goldman and others are stringing 60+ straight days of profitable trading in the market. They have essentially found a way to make the stock market completely predictable. My guess is they have enough information to predict price moves based on pending orders, and are exploiting that. If you can predict the future one second in advance, and use that information, the you have a great asymmetrical advantage.

      It’s like the phone company being able to listen in on calls and using anything they learn to their advantage.

  6. readerOfTeaLeaves

    You can see where this is going…the UK cannot credibly backstop its banks if they have trouble rolling their short term foreign currency borrowings.

    Whoops.
    Risk of vultures appears to be on the increase.

    1. john haskell

      whatever the problem is, banning insurance against the problem (e.g. credit default swaps) will fix it.

  7. Hal Horvath

    Perhaps the “global imbalances” China has helped to create are a bit more than only an abstract worry somewhere off in the hazy future.

    Wolf at one point said “dangerous.” I think he got it right.

  8. Bill

    Jesse also follows Zero Hedge and Market Ticker . Both good blogs , if you are NOT manic depressive . Sort thru the gloom on both for helpful info .

    I frequent Jesse’s and This blog the most

  9. Paul Repstock

    I don’t think the banks are being cautious about lending. They are just continuing their policy of refusing to lend at these rates because they expect the rates to at least double SOON!

  10. Paul Repstock

    By the Yves. I agree with your friends in the UK. The possibility of a devaluation looms very big.

    QE. is a dead horse. It may do some good internally, it does nothing for the export sector. Euro Zone could have managed with QE if the German government hadn’t been so afraid of the voters till it was too late.

    It remains to be seen if Mr. Darling can muster enough support for the idea. Certainly with the imbalance as bad as it now is, devaluation to more nearly par with the Euro must appear very good to him????? Who knows??

  11. dearieme

    @Paul, Mr Darling is no longer in office.
    @ndk: “I’m curious to see whether the U.K. would try to use anti-terrorism laws on itself.” I’d like to see the new coalition government use them on the old Labour government. Hanging’s too good for ‘em.

  12. pebird

    Can some explain how the UK can execute a “formal devaluation” of their floating currency? The last time this kind-of-happened (Soros) was when the UK tried to peg their currency to the ERM and eventually abandoned it to free float, but it was the market that adjusted the GBP.

  13. Paul Repstock

    It really need not be a formal devaluation. All they need to do is run the printing presses faster than their competitor countries. Or sell a stageringly large bond issue on the open market.

    Alternatively, they can do it with the popular press; like the recent disclosure of the empty piggy bank.

    The UK has the advantage over most of the other EU counties of still having control of it’s currency issue. The point is that they really don’t have any choice. Their share of the Greek bailout is greater than what the country recently raised with asset sales.

    1. Paul Repstock

      Another possible and faily obvious solution would be to begin buying Euro bonds at par with newly minted pounds.

      That would have immediate effect and really throw a spanner in the money works.

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