As tensions rise in the interbank markets, Brian Yelvington of Knight Research argues current levels might represent a ‘new normal’.
But first, an historical view (emphasis FT Alphaville’s):
The pre-2007 history of LIBOR-OIS is not very checkered, indeed from late 2001 to the beginning of 2007 $ LIBOR-OIS averaged 8bp with a standard deviation of 3.65bp. The high for the index came in November 2002 with 37.8bp and the low came in June 2006 with a reading of 1.9bp. € LIBOR-OIS has much the same story. During the same period the index averaged 6bp with a standard deviation of 1.9bp. The high for the index came in November 2002 with 18.4bp and the low came in April 2004 with a reading of – 1.75bp. Interbank lending amongst the highest quality banks was a pretty ho-hum affair.
Prior crises such as 9/11, stock market crashes, and the debt crises of the early Naughts and Late ‘90s (led by sovereign problems) were largely kept separate from the interbank lending markets. Even when a bank was fingered as being culpable, the interbank markets themselves did not re-price significantly, as only the suspect entities were in doubt. That changed during the last credit crisis as the entire banking system within the US became suspect, either through individual banking credit decisions (read: errors) or dependency on repo operations to pad outsized balance sheets.
click to enlarge
Thus far the 2010 period appears to be off to a “faster” start with respect to a rise in LIBOR-OIS. We believe this is due to investors immediately recalling correlation re-pricing to one in the prior period. The fear of a financial system on the brink causes investors to re-price interbank credit very quickly. Mitigating this fear should be a much quicker reaction time on the part of global central banks. Swap lines have already been reopened and upsized in some cases. It took a long time to get risk receding back to pre-crisis levels, despite massive amounts of quantitative easing in the 2007-2009 cycle. This cycle should see more focus and a keener response.
And what this all means for European and emerging market banks:
The reporting period for Euro-area banks is right around the corner and will stretch out for several weeks. We believe that investors are likely to be very critical of bank balance sheets in light of the current situation and will pressure management for disclosures – much in the same way the markets badgered banks in 2007 regarding their involvement in subprime mortgage assets. If disclosure takes the same iterative path as it did then, volatility is likely. Banks that only report their financials twice a year are likely to come under additional scrutiny. We reiterate that this could be far reaching. Aside from the implications that bank scrutiny has on interbank lending markets, emerging markets could be pressured as well. Euro area banks have 6x the lending to emerging market countries versus US banks according to the BIS ($3trn in Europe versus $500B in US and $500B in UK). Emerging markets have been considered a safe haven as of late owing to their growth rates. But with China demand slackening and lending under pressure, EM could suffer from two sides.
Related links:
Tensions rising in interbank markets – FT
Should CDS markets be more skeptical about European banks? – FT Alphaville
A missing €34bn of German exposure to Greece? – FT Alphaville
How bad in Europe? Your cut-and-paste guide – FT Alphaville