Friday, July 23, 2010

Economics 25/7/10: What lending markets tell us about EU policies

So the markets are not that enthused about the stress tests. After the initial bounce on the back of 'pass' grades, there are rising concerns about some 19 banks, including AIB, which were given 'all clear' with some serious stretch of assumptions.

But to see what is really going on behind the scenes, look no further than the actual interbank lending rates. In fact, the interbank lending markets provide a good reflection on the combined euroz one policies enacted since the beginning of the Greek debt crisis. Both euribor (the rate for uncollateralized lending across euro zone's prime banks) and eurepo (lending rates for collateralized loans between euro zone's prime banks) are significantly elevated on twin concerns about:
  1. The quality of the borrowing banks (recall - these are prime banks); and
  2. The quality of the collateral (with sovereign bonds being top tier quality, deterioration in sovereign debt ratings is hitting interbank markets hard).
Here are the usual, updated charts:

Chart 1Long maturities have been signalling extremely adverse effect of the Euro rescue package since its inception.

Medium-term maturities show severe deterioration since the euro rescue package. Steepest, and uninterrupted rise in 3 months euribor signals that the rescue package is faltering in delivering anything more than a buy-time for the euro… In other words, we have an expensive (€750 billion-sized) buy-in of short time.

The ECB claw back on longer term lending window did not help this process either. But the stress tests are doing nothing to stop the negative sentiment dynamics.

Chart 2Per chart 2 above, short-term maturities are showing that despite supplying underwriting to about a half of the full year worth of euro area bonds refinancing, the rescue package has achieved no moderation in the short-term risk perceptions of the market. In fact, the rise in euribor is more pronounced in the short term than in longer maturities, suggesting that short term risks of sovereign default remain unaddressed by the rescue package and are exerting a continuous pressure on interbank lending.

Introduction of the stress tests also did nothing to reduce overall cost of borrowing amongst the prime banks which were fully expected to pass the test even before the EU got on with setting test parameters.

In turn, all of this spells much higher costs of funding for the banks which have shorter term financing needs, such as the Irish banks. The implicit cost of taxpayers’ guarantee for Irish banks debt is therefore rising.

And panicked markets are not about to surrender their fears to the EU PR machine. With all the increases in the euribor, the volatility of the interbank lending rates also increased, across all maturities, as shown in charts 3 and 4 below.

Chart 3Chart 4As evident, in particular, from chart 4, in the longer term, credit markets are absolutely not buying the combination of the EU rescue package, ECB liquidity measures and the stress tests. Euribor trajectory for maturities of 6 months and higher firmly re-established and vastly exceeded volatility that preceded the pre-rescue panic. We are now worse off in terms of the cost of banks financing than we were before the Greek crisis blew up.

To remind you - Slide 5eurepo is the rate at which one prime bank lends funds in euro to another prime bank if in exchange the former receives from the latter the best collateral in terms of rating and liquidity within the Eurepo basket. Eurepo rates have posted dramatic increases since mid-June 2010. The original effect of the June 2010 closure of the longer maturity (12 months) ECB discount lending was a temporary reduction in the rates, followed by a stratospheric rise two week later that has been sustained through the end of this week. This is especially true for shorter term maturities, suggesting that part of the adverse effect was due to the heightened uncertainty around the EU stress tests. Chart 5 below illustrates.

Chart 5
Chart 6The u-shaped response in the interbank lending rates to ECB lending changes and to stress tests is even better reflected in the longer maturity eurepo rates, as highlighted in chart 6 above.

3-months and 12-months eurepo rates are now at the levels consistent with the height of the sovereign default crisis. There are significant differences in the rates by maturity group and vis-à-vis euribor due to the fact that the quality of collateral offered in the markets is now itself uncertain as sovereign credit quality continues to deteriorate both in terms of increasing probabilities of default and thus associated risk premia, but also due to the regulatory treatment of collateral that is being signalled by the stress tests.

As with euribor, eurepo rates are showing remarkable increases in volatility, for both shorter and longer term maturities.

Let us finally put the two rates side by side
to compare evolution of euribor against eurepo, setting index for all at 100=January 4, 2010

Chart 7
Chart 8
Some pretty dramatic stuff. To round off, recall that since the beginning of April 2010, the eurozone has undertaken the following measures to shore up its financial markets:
  1. Set up a sovereign rescue fund worth more than €750 billion to underpin roughly 50% of the total borrowing requirement in the euro zone (which could have been expected to yeild an improvement in banks collateral and thus a reduction in overall systemic risks in the interbank markets as well);
  2. Reduce maturity profile of ECB lending window (which was from the get-go equivalent to dumping more petrol on the forest fire);
  3. Deploy aggressive quantitative easing by the ECB (again, this should have reduced uncertainty in the interbank markets as in theory improved pricing for sovereign bonds should have increased the quality of interbank collateral and improve banks own books);
  4. Conduct an absolutely discredited stress test of the banks (designed to provide positive newsflow for the banks, especially for prime banks which should have seen their risk profiles reduced by a mere setting up of the test).
In short, none of the measures seem to be working, folks... May be, just may be, the real problem with EU banks is their unwillingness to come clean on loans losses and start honestly repairing their balancesheets?
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