Europe’s liquidity crisis: I had a long lunch meeting on Friday with a hedge-fund manager with an astonishing ability to navigate the Bloomberg Blackberry app. And there was one chart in particular… the 3-month Euribor/Eonia spread… it’s fantastic if what you’re looking for is a guide to how stressed the Euroland funding market is.
This chart comes from a 40-page note on European bank liquidity published by Daniel Davies and Jag Yogarajah of Exane BNP Paribas; I can highly recommend you try to get yourself a copy of it somehow….
European banks have lots of European sovereign debt. European sovereign debt is falling in value. Therefore European banks are insolvent. Therefore, they have greatly increased credit risk. Therefore, spreads are rising. Except, this isn’t really true. Greek banks are insolvent, it’s true, if you mark their sovereign debt exposure to market. But to a first approximation, no other banks are…. What is true is that Europe is in the middle of a textbook liquidity crisis. Banks are not lending to each other — and the ECB isn’t stepping in to solve the problem. This is a serious structural issue with the way that the European monetary system was constructed: the ECB is tasked only with guarding inflation, and not with ensuring the health of the banking system. Individual national central banks are meant to do that. But they can’t print money — only the ECB can. So when there’s a liquidity crisis, no one’s able to step in and solve it.
Here’s another chart from the report:
The light-blue line is the share prices of US banks…. Who caught that falling knife and stabilized US bank share prices? Not Treasury, but the Fed, with its quantitative easing. As soon as that started (see the dark blue line), US financial institutions suddenly looked as though they’d be fine. For this reason, the Exane analysts are convinced that talk of European bank recapitalizations is silly — essentially, it’s treating the wrong disease:
There is no reasonable amount of capital that can cure a liquidity shortage. The reason why people are refusing to lend to the banks is not primarily because they fear an underlying solvency problem (although some people do), but because they fear an obvious and immediate liquidity problem. It is rational not to lend to an institution that you believe to be illiquid.
The real problem here is simply that banks are hoarding their cash and not lending to each other…. And the way the banking sector works, banks have to be constantly lending to each other…. The overnight interbank market is the bloodstream of the European financial system, and the flow of blood is coming to a halt. Or, as the Exane report puts it, “if we think of wholesale funding as commodity input, it is much more like the supply of limestone to a kiln than the supply of flour to a bakery – not only can the banking sector not produce loans without new financing, it cannot shut down for a short period of time either, it needs constant supply.”…
You can see the dilemma facing the ECB…. It’s facing a dual liquidity crisis: not only within the European banking system, but also at European sovereigns. And it doesn’t really have a mandate to address either one.
But it’s liquidity crises which are the most violent, and which can kill a financial system — indeed, an entire economy — more or less overnight. Someone in Europe needs to come up with a plan for how to address the current crisis — now. Because if it gets any worse, it could well be too late.