Counterparty risk fears escalate in Europe (NakedCapitalism)

SUNDAY, MAY 16, 2010

European Interbank Markets Stress Rises Over Counterparty Fears

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.