Desperate times call for desperate measures. With investors fretting over European bank exposures to the wider sovereign crisis, five central banks intervened last week, announcing dollar liquidity measures in an attempt to shore up confidence and keep short-term funding channels open.
But while market players say that the move provided a temporary boost to sentiment, mounting concerns over the scale of the eurozone sovereign debt crisis – and whether or not politicians have the will or ability to resolve it – threaten a deeper banking crisis than that seen in 2008.
“All eyes are on the European politicians,” says Michael Gower, head of long term funding at Rabobank. “They have the keys to solve the problem. It’s a difficult problem but they need to find a resolution otherwise Europe will end up in a permanent cycle of kicking the can down the road and going from crisis to crisis.”
FUNDING FEARS
Fears of a short-term funding crunch have been growing since June, when Moody’s put three French banks on review for downgrade because of their possible exposures to Greece.
This prompted US money market funds — major buyers of short term European bank paper — to reduce their holdings by reducing outstandings, allowing deals to roll off and not replacing them, and shortening up maturities. Between the end of May and the end of July the 10 largest US money funds reduced their exposure to European banks by 20.4% on a dollar basis, according to Fitch Ratings.
“Since June when Moody’s put the French banks on review we’ve seen a decline in demand for continental European names,” says Chris Conetta, head of global commercial paper trading at Barclays Capital in New York. “Activity in French banks slowly deteriorated, Spanish and Italian bank demand came to a halt.”
Tensions in the eurozone have skewed cross-currency basis swaps, allowing euro funding sovereign, supranational and agency borrowers to print dollar deals at very attractive levels, but making it hard for banks raising dollars for dollar funding needs to compete.
The three-month euro/dollar basis swap gapped out at the beginning of August – it was around minus 110bp earlier last week, having been in the minus 30s in June.
For what dealers believe is the first time ever, the sovereign, supranational and agency (SSA) sector has overtaken the bank euro commercial paper as the largest. Outstanding issues of bank debt totalled $231 billion on August 31 according to Dealogic, and SSA outstandings were $238.4 billion. This compares with $235.1 billion for banks on July 31 and $214.9 billion for SSAs.
The likelihood of downgrade and pullback by US money market funds has resulted in a sharp sell-off in the shares of leading French and Italian banks. Shares in Societe Generale have fallen by almost 50% since the beginning of August 1, while BNP Paribas and Credit Agricole have both seen more than a third shaved off their market valuations.
Things came to a head on September 14, when Moody’s downgraded the long-term unsecured debt ratings of two of the three French banks – Crédit Agricole and Société Générale – that it had put on review in June by one notch.
While the downgrade was not as large as some market participants had feared – and Moody’s held off on a downgrade of BNP Paribas, keeping its long-term debt rating on review – the announcement and freeze-up in dollar funding was clearly enough to spark central banks into action.
Just a day later, the European Central Bank, the US Federal Reserve, the Bank of England, the Swiss National Bank and the Bank of Japan announced that they would hold liquidity operations to provide funding of about three months to cover the end of the year.
Market participants say that the liquidity facility announcement, and the fact that the downgrades were not as severe as had been feared, provided a temporary boost to sentiment.
But the impact was short-lived. “We had a policy move last week which improved sentiment, but on Monday morning spreads were already back to where they were early last week,” says Alberto Gallo, senior credit strategist at Royal Bank of Scotland in London
Shares in European banks also continued to fall after a brief reprieve, with Soc Gen’s share price falling 6%, BNP’s down 2.8%, ING down 5.6% and Raifeissen International down 5.2% on September 19.
SOLVENCY SECURITY
Despite the sell-offs, investors point out that European banks remain solvent and continue to have access to short-term funding.
Federated Investments in Pittsburgh hasn’t reduced its aggregate holdings of European bank paper but has shortened up on duration – typically slashing durations by around half. It only has exposure to the top banks in about nine countries worldwide.
“We’ve had good information from banks over their exposures to the European periphery, and when we stress that data in a pretty draconian way we are still left with good, solvent institutions,” says Deborah Cunningham, chief investment officer for taxable money markets and senior portfolio manager at Federated Investments. “It’s not an issue of solvency or ultimate repayment.”
The banks, for their part, stress that they have continued to access dollar funding from the market cheaply – by borrowing in euros from the ECB and swapping to dollars, for example.
Furthermore, market participants say that the funding situation in Europe has improved a bit since August, and banks have been getting some good-sized trades done.
“Since the start of September, banks have tried to recapture market share,” says Kieran Davis, head of euro commercial paper trading at Barclays Capital in London. “Conditions aren’t perfect for them, but [from September 8-13], banks have raised decent volumes of short-term paper. It’s been mainly those in the safe-haven jurisdictions such as Nordic and Australian, but there have been some flows for French, Spanish, Italian banks.”
Investors also appear to be differentiating between banks in Europe more than before.
"Since the start of September, there have been brief periods of better availability of liquidity and duration, but that is only for the top few banks in Europe. The others are challenged duration-wise and volume-wise, both in the European and the US markets, but the US money market funds have been the most visible example of this pull-back."
LESSONS LEARNED
Banks in core eurozone nations are also far better prepared for funding problems than they were in 2007 and 2008.
For one thing, although unsecured funding conditions have undoubtedly got tougher, many banks have good-quality assets on their balance sheets they can use for secured funding such as repo.
“The national champions have a lot of quality assets on their balance sheets, much better quality than in 2008, and therefore the opportunities for secured funding are better,” says Conetta.
“Investors in the US and Europe remain happy to lend to national champion banks in secured form. We have yet to find investors in the US which have changed their repo lending behaviour to French banks, for example.”
Banks have also reduced their reliance on short-term funding since 2008 and have cash stock-piled. In spite of all the scrutiny on French banks and dollar funding, for example, Société Générale announced this week that it had $34 billion of cash on deposit at the Federal Reserve as of the end of August. They can also cut or reduce business lines in reaction to tougher funding conditions, and many are well ahead of their long-term funding programmes for the year.
HOLDING UP... FOR NOW
Short-term funding markets have therefore yet to seize up, and liquidity conditions are not as immediately dire as they were in 2008.
“The difference this time around, compared with 2008, is that there is more liquidity out there in general,” says Henry Buckmaster, head of sales at Prime Rate Capital Management in London.
“There’s more money swilling around out there, liquidity from money market funds as well as bank paper being trading on the secondary market. In 2007/2008 at points you wouldn’t lend to your best friend overnight, that isn’t the case [now]. Perception of banks has changed too, restructuring of balance sheets continues.”
Of course, central bank liquidity provision has helped. It has eased investor fears over liquidity risk, and the more emphasis on this, the more it will help to shore up investor confidence.
“Central banks need to emphasise the liquidity available in the system in order to make lenders more comfortable with lending to European banks,” says Cunningham at Federated Investors. “The more coordination and solidity among central banks the better.”
Furthermore, Libor has yet to spike up in the way it did in 2008, while use of the one-week dollar-swap lines at the ECB has so far been limited, suggesting continued access to funding. Two banks borrowed $575 million last week.
“As much noise as there is about the one-week ECB tender, it hasn’t been getting hit that much,” says Alex Roeder, head of short-term fixed-income strategy at JP Morgan in New York. “$575 million is not a very big number, and two banks out of the 6,000 eligible isn’t much.”
FUNDAMENTAL WORRIES
But although the short-term funding markets have proved more resilient than in 2008, prolonged tension in funding conditions raises questions about banks’ business models.
“The issue is not liquidity but long-term solvency and profitability of earnings,” says Gallo.
“New lending is not attractive at current funding costs, and that’s why equity valuations are so low. On the other hand, banks hoard cash and do not lend to withstand funding and debt roll-over risk. Without a consolidation process, a reduction in spare capacity, it will be hard for the existing banks to have earnings potential and therefore come back to normal funding levels.”
And while central bank liquidity provision is helpful, problems in the short-term funding markets won’t ease until the fundamental issues behind them — the sovereign funding crises — are solved.
“Now it’s not just a case of whether you like a bank but whether you like the sovereign behind it,” says Buckmaster at Prime Rate Capital Management.
The sheer size of the problem is the major issue — money markets aren’t broken in the way they were in 2008, but the causes of the tension in short term funding are even bigger, and very difficult to solve.
“The situation is much worse already than in the credit crunch of 2008 because the entire European system is in a much more strained position than it was then,” says Michael Gower, head of long term funding at Rabobank. “In 2008 very specific banks had problems, but now the whole European banking system is at threat, because the strength of Europe as a region is questionable.”
Policymakers need to act together and decisively to shore up confidence. The market needs decisive action over support to the European periphery – and there are major concerns that policymakers lack the ability or will to undertake such action.
Rabobank’s Gower believes that politicians can still find a solution to address the sovereign crisis – but that time is rapidly running out.
“They’ve still got a chance to put an adrenaline shot in the European Financial Stability Facility funding plan,” says Gower. “If they quadrupled the size, for example, and could show how that would be funded, and that everyone is writing the cheque, then that would give a lot of stability to the periphery. Anything less than that and the boat will carry on rocking. We need a very definitive political move very quickly.”
Others believe that deleveraging of the banks is key. “Banks need to de-lever to become profitable. Without de-leveraging, an equity recapitalisation for the banks would be a bit like pouring water into a leaky bucket,” says Gallo. “Adding leverage to an EFSF vehicle would create a structure with a volatile rating profile.”
But whatever the solution, investors aren’t going to be comfortable buying bank paper when it is unclear how those banks will be affected by the sovereign debt problems in the eurozone. Only coordinated action from policymakers can bring confidence back to the system and put money markets back on an even keel.