That the European Central Bank has stepped in to replace much of the eurosystem liquidity that used to be provided by the banks’ themselves is well-known. Did you know, however, that one measure of the ECB’s liquidity provision is now higher than in the depths of the 2008 financial crisis?
It’s the ECB’s so-called ‘recycling’ of bank deposits, where the central bank lends out excess funds deposited at it by banks to other, perhaps weaker, banks. The chart comes from Standard & Poor’s equity research team, who published a 118-page note on European banks late on Tuesday.
There’s more in it, however, than just the hefty importance of central banks in inter-bank markets, which have traditionally been dominated by (private) banks. There’s also the mention of a new role being played by non-bank financials such as money market funds, which are included in the chart.
Here’s what analysts Tony Silverman, Frank Braden and Jawahar Hingorani say:
It is of course only natural that some banks may have a surplus of deposits whilst others are in the opposite position. However we believe reality probably is not quite so simple and in this connection we highlight the conspicuous scarcity of banks in our coverage that are net lenders in the inter-bank market. At least part of the answer may lie in the inclusion of independent money market mutual funds in the ECB statistics … “Inter-bank” is perhaps no longer an appropriate name for the market. Also, currency swaps are used and so the money market funds may be in other currencies. These factors add a further layer of instability to bank funding in our view.
Indeed, the Bank of England has also mentioned “market intelligence” claiming some banks may be funding themselves by absorbing the unsecured deposits from non-banks, including money market funds. There’s the suggestion by S&P too, that these funds haven’t been getting particularly good deals what with the current, very low overnight rates. That, they say, could be set to change as “funding will come to be seen as a valuable resource which banks will pay more for in due course.”
There’s even more from the S&P report though.
They reckon that the introduction of the eurozone has also wreaked havoc with banks’ traditional funding systems. So much havoc that some banks might have to cease existing altogether:
For banks in economies that hitherto had a history of external payments deficits and currency depreciation, the introduction of the euro brought with it a new and specific risk. Previously domestic currency used to buy imports would be returned to domestic banks when, in simple terms, importers sold the currency and exporters picked it up through the foreign exchange market, at an exchange rate which (ex capital flows) equalised the two amounts. In contrast, funds to the value of the deficit are now permanently lost to the domestic banking system’s private sector deposit base. The new reality is that external payments deficits constitute a funding threat to domestically focused banks. The resulting funding deficit is, in large measure and in current circumstances, met by the ECB. We would question whether this is sustainable and indeed to what extent such funding can meaningfully be regarded as temporary.
A related issue is that asset price declines (in practice primarily real estate) relative to ‘core’ euro zone countries would previously have been achieved, at least in part, by currency devaluation. So borrowers of domestic currency applied to acquiring domestic assets remained solvent, whilst loans and depositors’ funds lost relative value. However now that both banks’ liabilities to depositors and borrowers’ liabilities to banks retain value, banks in these countries are operating in a new and far less favourable environment for loan loss provisions.
In principle we see both these features as arguments in favour of more banks operating with an EU-wide deposit and lending base, at least if the euro project is to remain intact. This may mean peripheral countries would not necessarily have their own domestic banks. We acknowledge the scenario is rather against the current trend of events in light of the limited scope to resolve stressed banks on a genuinely cross-border basis, as demonstrated over the 2007-2008 financial crisis. However the ability of deficit countries to resolve stresses in their banks by themselves is, of course, now equally in question as well. At the end of the day, the need, in our view, is for EU wide banks alongside an ECB with appropriate powers.
Inter-bank minus the bank, and the domestic peripheral ones too. Most interesting.
Related link:
When European interbank volatility is good for money funds - FT Alphaville