Chart of the Day: European bank funding starting to dry up

This post title and chart of the Euro FRA/OIS 3 month spread is from Bloomberg via Andy Lees.

Euro FRA/OIS spread

FRA/OIS is a proxy for the cost of interbank borrowing. If you want to know what it means, it measures the spread between floating rate agreements and the overnight indexed swap – some instruments key to bank funding. Forget about those specifics because for the layman the point is that during the credit crisis of 2008 you could see similar changes occur during the lead up to panic. The Ted Spread and Libor-OIS spreads were good signals of liquidity constraints and funding distress in the interbank market for the American banks. See Libor-OIS spread at an all-time high from September 2008 as an example.

Today, it is euro banks that are the problem. For example, Goldman Analyst Alan Brazil suggests that euro banks need $1 trillion in additional capital. An example is a post in today’s German-language Handelsblatt about the 1.5 billion euro hole in Austrian bank Hypo Alpe Aldria’s balance sheet, a bank we have flagged as a problem in the past as a key link to the problems in Eastern Europe.

This has created distress in funding markets, particularly because of US money market funds concerned about exposure to European banks. And people are looking to track that distress Euro FRA/OIS is one way.

  1. gaius marius says

    edward — i get this, and understand that US mmkt funding withdrawal from eurozone banks has provoked it.

    my question, though, follows from this: in 2008, we were faced with a collapse of unregulated shadow banks that the Fed could do very little to fund, and the forced delevering of those entities laid waste to all before them. in 2011, these euro institutions are not shadowy at all — the ECB can fund them straightforwardly. it seems to me that, even if the euro interbank market ceases to function, there is no need for real alarm…

    … IF the ECB does its job. it further seems to me that if the ECB cut its equivalent discount window rate below the current rate on offer through the interbank market, the crisis should judder to a halt. the EFSF will soon enough be swapping its own paper for periphery debt with eurozone banks, resolving the asset side issues.

    so the question: why then would the ECB not do exactly that — lower its equivalent discount window rate 25bps or so and continue acting as the bridge to the EFSF?

    1. Edward Harrison says

      On another thread ( I was talking about low rates and what good they do. My comment was as follows:

      “The easy but flippant response is “I don’t know “. The Fed controls rates and it has moved to not just controlling overnight rates but also to controlling the rates further out to two years.

      “People like Scott Sumner argue rates should be negative in real terms because of the Taylor rule. But the fact is rates are not market determined now so the price signal is defective.

      “My view is rates should be positive in real terms and the Fed should provide liquidity as needed for liquidity constraints because low rates are more about solvency than liquidity. Bagehot said liquidity at a penalty rate.

      “If government wants to prevent debt deflation, it can always manufacture more net financial assets via deficits without propping up bankrupt enterprises and promoting resource misallocation.”

      Low rates are no panacea for capital impairment. What the eurobanks need is capital not low rates because this is a solvency problem.

      1. gaius marius says

        i do agree of course that fiscal deficit spending would go much farther. but in the meantime i’m not sure capital impairment in the banking system is really a big deal — banks too frequently go insolvent for many years, a la all major US banks in the aftermath of the latam crisis of 1982. the trick is making sure those banks continue to be funded and can then earn their way back to solvency over a prolonged period, thereby voiding the need for fire sales.

        in other words, low rates and liquidity provision can prevent a solvency problem from turning into a deflationary disaster. would you agree?

        1. Edward Harrison says

          That approach produced the S&L crisis. There is no free lunch. In this environment of recession-prone economies, I think that approach would be disastrous.

        2. David Lazarus says

          It also ignores the problems to the rest of the economy from too low interest rates. Pension annuities will suffer from low interest rates. That could deter pension savings. Then it encourages excessive asset lending which was the initial problem. Low interest rates do not allow efficient capital allocation. Asset speculation takes over from business investment.

          Allowing banks to trade their way back to health will hamper government revenues, as they will have billions of tax losses to use. If the banks were wiped out the tax losses would be wiped out. Meaning that banks would be paying taxes rather than exhausting their TARP subsidised tax losses.

      2. gaius marius says

        i mean, things like this…

        … have to be halted in their tracks or europe can too easily burn to the ground.

        1. David Lazarus says

          Yes but deleveraging has to run its course. Banks lent excessively and while this sell off can be overdone it is a clear indication that banks were never that well managed to start with. The Basel risk rules were always going to lead to problems since banks never really appreciated the risks. They should have been rigid rules without allowances for flexibility.

  2. Anjon says

    Thanks Ed! I linked to this story and your chart today and had a post on it.

    Wasn’t Bagehot’s rule something like “lend freely, at penalty rates, against good collateral”?

    Is what we have in the age of Zombies “lend freely (only to Zombies, stingy to all else), at free rates, against crap collateral”

    Can the ECB just keep the zombies flying indefinitely, by “extended extend and pretend”, lending freely at free rates against impaired assets? If that is the case, the only way an outsider may see problems might be in progressively worse income statements, as their impaired assets generate lower and lower earnings? Do i have this right?

  3. adsanalytics says

    One interesting meme out there is that banks are actually overfunded which is why BONY and others are beginning to levy charges on large deposits. Yes libor/OIS spreads have widened and there is still a lack of transparency about European bank balance sheets, however, however we are a long way from 2008, that is, if you trust the usual indicators.

    There are two Fed financial conditions indicators both of which are sending a benign signal:

    Our own Financial Conditions indicator is somewhat less benign.

    1. David Lazarus says

      There has been a withdrawal of money market funds from Europe as they fear bank collapses. Once these banks start collapsing the problem will appear on Wall Street as CDS payouts will become due. It will be an issue of which bank has exposure to CDS. Then will the Fed come to the rescue again? Or can they afford it?

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