Opinion

Felix Salmon

Europe’s liquidity crisis

By Felix Salmon
November 14, 2011

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 which he clearly pulled up on a regular basis: the spread on senior unsecured bank debt in Europe. As Lisa Pollack points out, it’s tempting but dangerous to look at the iTraxx Senior Financials index in this context, because it’s an easy index to follow but it also includes non-bank names like Aviva, Axa, and Munich Re. So here’s the 3-month Euribor/Eonia spread, instead, which also has the advantage of going back to 2007. It’s not the best indicator when it comes to measuring banks’ cost of funds, but it’s fantastic if what you’re looking for is a guide to how stressed the Euroland funding market is.

euribonia.tiff

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. And in fact the situation is worse than this chart makes things look, since in the months immediately following Lehman’s bankruptcy, the three-month interbank funding market effectively did not exist, and the numbers being charted here are, in the note’s words, “arguably somewhat hypothetical“. Take out the nonexistent market following Lehman’s collapse, and spreads in Europe are right at their all-time highs.

We all know why this is, of course. 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. Mark French banks’ holdings of Italian sovereign debt down by say 10%, and they’re still fine; their capital drops, of course, as it would with any write-down, but certainly to nowhere near zero.

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:

datastream.tiff

The light-blue line is the share prices of US banks. They fell steadily through all of 2008 and the beginning of 2009, with TARP barely making a difference. 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. Look at the way that bank debt issuance has fallen off a cliff — even the issuance of covered bonds, which to a first approximation don’t have any credit risk.

term.tiff

And the way the banking sector works, banks have to be constantly lending to each other: in nearly every country in Europe, the amount of bank debt coming due every day is higher than the total amount of bank capital in the system. 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.”

And here’s how a recent BIS report put it:

Quantitatively, private liquidity dominates official liquidity… private global liquidity is highly cyclical because it is driven by divergences in growth rates, monetary policies and, above all, risk appetite.

Private liquidity can give rise to international spillovers… This international component of liquidity can be a potential source of instability, because of its own dynamics or because it amplifies cyclical movements in domestic financial conditions and intensifies domestic imbalances.

The liquidity situation at European banks is similar to that at the sovereign level, too, as James Macdonald explains very cogently. Italy’s debt, it turns out, is not particularly high, by historical standards.

macdonald.jpg

Instead, the problem is that Italy is being forced to roll over its debts on a regular basis.

Before World War I, countries considered truly creditworthy borrowed on terms that are unrecognizable nowadays. The vast majority of their debts were in the form of perpetual annuities…

In 1900, for example, France had a public debt amounting to 105% of GDP; but over 96% of it was in the form of perpetual annuities, and less than 4% in the form of short-term Treasury bills. Therefore the country’s annual funding requirement was only 4% of GDP. The credit of a country with such a debt structure was virtually impregnable short of a world war.

Since those halcyon days, however, western governments have raised their debts on a far shorter-term basis… France, with a public debt of (only) 86% of GDP, now has an annual funding requirement equivalent to over 20% of GDP. It is in good company. Belgium Italy, Spain, and Portugal also have to finance 20-25% of GDP each year. The USA has a funding requirement of nearly 30% of GDP, thanks to the folly of the Treasury Department’s decision to stop selling the 30-year T-bond in 2001 in a misguided attempt to shorten the average duration of the debt.

The result is that the sovereign borrowers that the markets have been accustomed to think of as “risk-free” have become a little similar to banks… At any time, a ripple of suspicion about their long-term ability to repay their debts (not unreasonable given the relentless build-up of their off-balance sheet liabilities since the war) could set off a chain reaction which ends up with a self-defeating rush for the exits.

This is what is happening to Italy.

You can see the dilemma facing the ECB here. 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.

Comments
7 comments so far | RSS Comments RSS

Hey Salmon, remember that tennis court cartoon you featured back in the dark days of 2008? Same thing.

Great post, by the way. Fits in with Warren Buffett’s call this morning too (see Harrison’s credit writedowns for the video)

Posted by ottorock | Report as abusive
 

If you believe David Rule, writing in April 2008 (as ISLA CEO; he since moved to the FSA), there was no interbank money market – represented by Libor, Euribor etc -to speak of then (pre-Lehman) and several years before that and it had little to do with funding problems:

“(…) for a couple of reasons three-month Libor may not now be the best measure of short-term interest rates.

First, it is no longer a good proxy for marginal bank financing costs. A Libor-contributing bank submits the rate at which it believes it could borrow funds, were it to do so by asking for and then accepting interbank offers in ‘reasonable market size’’. However, the interbank market for unsecured three-month deposits has been thin for a number of years.

Only unsophisticated banks place deposits with their competitors at maturities beyond one week. Liquidity management and credit limits deter banks from tying up their funds in this way. Rather the interbank deposit market is overwhelmingly overnight.

At longer maturities, banks borrow unsecured primarily by issuing securities to non-bank investors.”

http://www.ft.com/intl/cms/s/0/044a0278- 0652-11dd-802c-0000779fd2ac.html#axzz1dc UxGXqK

Which raises the question: what does Euribor actually measure?

Posted by Kamekon | Report as abusive
 

I am also puzzled by your statement that “the ECB isn’t stepping in to solve the problem” (of banks not lending to each other).

Uh? As today’s NYT puts it, fairly accurately in my opinion:

“Since the beginning of the financial crisis, the E.C.B. has been lending euro area banks as much money as they want, trying to maintain the liquidity that is the lifeblood of the global financial system.” ( http://www.nytimes.com/2011/11/15/busine ss/global/as-european-nations-teeter-onl y-lenders-get-central-banks-help.html?_r =1 )

And there is the ECB itself:

“The ECB normally aims to satisfy the liquidity needs of the banking system via its open market operations.” ( http://www.ecb.int/mopo/liq/html/index.e n.html )

The provision of liquidity is normally done via the NCBs, but that doesn’t change a thing, it’s still the Eurosystem. Finally, although it’s true that the Eurosystem’s primary objective is maintaining price stability, that of course is not its only objective or task, as the Eurosystem/ECB Statute clearly shows: http://www.ecb.int/ecb/legal/pdf/en_stat ute_from_c_11520080509en02010328.pdf .

I would have thought that you are aware of at least the gist of all this, but could you then explain what you mean by the ECB not stepping in etc.? (And where do you think the banks are hoarding their cash?)

Posted by Kamekon | Report as abusive
 

It is not just the euro zone that currently is in the midst of a liquidity crisis. US bond markets are experiencing record low liquidity as well. I sat in on a luncheon last Wednesday with Dan Fuss of Loomis Sayles Bond at the Seattle CFA Society, who said that Loomis’ internal liquidity scores for investment grade, high yield and treasuries were all at very low levels. Indeed, if we look at treasury liquidity through the lens of volatility, treasury liquidity is currently the worst it has ever been. From 1962 to 2008, the annualized six month standard deviation of 10yr treasury yields only seldom popped above 15% of the average yield during the period. It is currently at 27%, even with its previous record high volatility in late 2008/early 2009. As Mark Gongloff recently wrote on the WSJ blog (paraphrasing the Bank of Canada governor), “liquidity is the Kaiser Soze of the global financial system.”

Posted by bardluippold | Report as abusive
 

Volatility of treasury yields looks high because yields are at record lows. Hell, when 10 year rates are at 2%, any move looks huge. If you measure it in DV01, it’s not that high.

Posted by Bernanke | Report as abusive
 

I would argue that perpetual annuities are credit instruments and not debt instruments, since there is no obligation to repay principal, although there may be the right.

For example a small rump of 2.5% redeemable UK Consolidated Stock (Consols) still exists, and I would argue that these perpetual annuities are akin to a 2.5% redeemable preference share in UK Plc. There’s certainly no debt obligation.

In fact, the name ‘stock’ derives from the old tally stick system of government funding. When the government borrowed, a tally stick was split as evidence of the debt owed by the government as the ‘foil’ holder to the creditor as holder of the ‘stock’.

Whoever held stock could present it in payment of taxes and this reduced the amount of money/credit in circulation in a not dissimilar way to using an Air Mile against air travel.

Posted by ChrisJCook | Report as abusive
 

Spare me the details: how can I make a profit from it? Looking back, fear of “inevitable” inflation kept me from some insured CDs that I wish I had now.

Posted by walt9316 | Report as abusive
 

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