The Interbank Markets Are Malfunctioning (Again)24 August, 2011, 12:29. Posted by BM
Tags: Banks, Europe, European Banking system, European banks, Financial
The markets are now back into panic mode. Last Wednesday, an unnamed European financial institution used the emergency dollar funding facility from the ECB to obtain US$0.5bn. While the amount itself is small size, the event is significant as it is a reflection that the interbank markets are malfunctioning, again. Allow me to elaborate further.
So post the financial crisis, revenues for European countries have weakened while liabilities such as pensions etc. remains absolutely daunting. Concerns regarding sovereign risk are not completely unfounded. When questions are raised about the sovereign this broadly has three key impacts on the banking sector.
(1) Banks hold government bonds, and when the latter falls in price, the capital position of the bank is negatively hit
(2) Banks hold government bonds as collateral, for funding and other purposes, so when the bonds fall in value the collateral value also gets hit
(3) Due to close ties between the sovereign and the banking system, when the sovereign is downgraded, the banks in that country are also likely to get downgraded, causing the funding cost to rise
With increasing globalization European banks hold a lot more foreign currency assets than what they used to in the past. In particular a lot of them hold US assets. What they typically do here is obtain dollar funding from the US interbank market. But when question marks on the sovereign are raised in Europe, US banks become a lot more cautious in the interbank market when lending to their European counterparts.
As such, many European banks have turned to obtaining euro funding from the European interbank market, and using a USD/EUR cross currency basis swap to in turn obtain the dollar funding. This is why we have seen the violent moves in FX swaps recently.
Should both these methods fail, European banks can go to the ECB for emergency dollar funding. Here the size is unlimited, whilst in the two previous methods large size may move the markets. The current cost of all three methods are not far off, but the ECB dollar funding requires a 12% initial margin. So everything else equal one could logically expect that avenue to be the last resort measure.
Compared to late 2008 when the ECB emergency dollar funding usage was US$300bn, the current $0.5bn almost seems insignificant. However it does signal that the interbank markets are malfunctioning, which is certainly not good sentiment wise. But with funding backstops put in place by Central Banks, we probably don’t need to scare ourselves too much about this dollar funding issue. The biggest risk right now is a global economic slowdown, and this doesn’t necessarily have a great deal to do with dollar funding.