Thursday, July 22, 2010

Bank Stress Tests and Its Impact on Inter-bank Lending

This article attempts to explain the 3-month Euro-Libor and Euribor rates and their recent steady increases, which is due to a strain European inter-bank lending market. The 3-month Euro-Libor and Euribor rates are what banks say they would pay for a short-term deposit in Euros. In terms of calculating each rate, the British Bankers Association takes out the top 4 and bottom 4 from the 16-bank survey, and then takes the average of the remaining 8 banks to come up with the Euro-Libor. The European Banking Federation takes out the top and bottom 15% of the 42 banks surveyed and averages the rest to come up with the Euribor rate.

Recently the 3-month Euro-Libor rate compiled by the British Bankers Association has increased. Monday's rate of 80.81 bps was 1.81% higher than Friday's rate. These are the highest Euro-Libor rates since the end of August 2009. The same can be said for the 3-month Euribor, which has risen each day since April 21. These steadily increasing rates continue to show stress in the European inter-bank lending market.

Since the end of May, dollar Libor rates have drifted lower. It is possible that credit strains were being over exaggerated by market participants and that banks are willing to take a little more risk in lending dollars. However, it should also be noted that these rates have only drifted slightly lower and have not in any way, dropped significantly. The graph below depicts the movement of both the 3-month dollar and Euro Libor rates.

There has been almost a 40% in the Euribor rate since the end of March, signaling the bank strains.

Thursday morning, there were reports that 2 large Irish banks had passed the tests. This came with a grain of salt as it was also reported that assets were sold to raise cash to improve the banks Tier 1 capital ratio. Tier 1 ratio is the ratio of equity capital to ones assets. The stress tests will attempt to shed some light on how capitalized banks are by testing their Tier 1 capital ratio, how they would hold up in a faltering economy, and against a sovereign default. The following chart shows a stress test ran against 19 US banks.

Friday, the EU Commission will release the results of the stress tests on 91 banks in the European Union. There have been various reports that some of the banks have not made out favorably. These reports have sent inter-bank lending rates higher. As the perceived risk of the loan rises, so does the rate of interest charged for the loan. Another possible reason for this recent spike in Euro lending rates may have come at the expense of the ECB.
A recent report describing banks taking less credit than expected from the central bank may have reduced liquidity enough in the markets to push rates higher.

However, if the stress tests were to come back favorable, showing many banks are well capitalized and prepared to handle these different economic shocks, we could see rates move lower.

So where I am looking to put money? In small Irish banks. Their recent sovereign downgrades to Aa2 on Monday have left share prices relatively cheap. For this we look to The Bank of Ireland, IRE, and Allied Irish (AIB) as solid short term investments.


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