Tuesday, July 13, 2010

A Peak Into Europe's Bank Lending Problems

There has been a lot of talk on stress tests and such over in Europe and what its impact will have. This article aims to look at the consequences of these tests but we will first take a peak into European money markets to gauge how bank lending is behaving.

The first rate we will look at is the 3-month Eonia. This is comparable to the 3-month OIS rate in the United States that is it represents expectations of interest rates in the coming months, set by the ECB as opposed to the Fed. Recently this rate has surged due to banks borrowing less from the ECB than expected, thus creating less liquidity in the market and in turn, driving rates up. ECB President Jean Claude Trichet has come out and said that these rising costs will not affect the ECB or its decision to raise its benchmark rate from 1% and should not be confused with a tightening of monetary policy. In Europe, fears of a double dip are much greater than the inflationary environment that could result from keeping rates low for such an extended period. So this recent rising of rates may cause a bit of tension in terms of lending between banks.

This rising rate (3-Month Eonia) has lead to an extreme tightening of the spread between itself and the 3-month Euribor, the rate banks would charge each other for the lending euros. It should be said that a tightening of a credit spread, such as this one, would certainly be pointing towards a healthy and normal inter-bank lending system. However, the cost of borrowing, Euribor, continues to soar and the tightening of this spread is completely due to the rapid increase of expected future interest rates.

The graph below depicts the 3-month Euribor; the rate banks would charge each other to borrow Euros. It has been rising each day since mid June.

So, in order to take a more appropriate measure of the health of the European banking system, we will look at European TED spread. Taking the 3-month Euribor and subtracting it from the yield on German 3-month Bubills, we are able to calculate the spread. This can be compared to the US TED spread, which is calculated in a similar fashion, subtracting the 3-month Libor from the yield on 3-month Treasury bills. It should be noted here that the European spread has continued to rise, compared to its US counterpart spread, which has come down off recent highs. The recent high in the US spread should be taken with a grain of salt, since it was driven by a reduced 3-month T-bill yield. The yield plummeted as new regulations set by the SEC on liquidity risk, interest risk, and credit risk caused a surge in demand for Treasury Bills by money market funds. But that’s neither here nor there. The point is that the European banking system continues to show strains and that the US seems, FOR NOW, to be outside of it.

This week, the EU is testing 91 banks across the area. Now with this all being said, what type of shock will the results of the European bank stress tests have on inter-bank lending in Europe? Conventional wisdom would suggest that one is asking, well it depends on the shock? This would be a solid assumption. I plan on covering the what-ifs in terms of a negative results, since my thinking is that most banks will come bank on the insolvent side of things. My other feeling is that it seems like it's only a test of whether a sovereign default can bring down a bank. That being said, it will certainly hang out to dry who is exposed the most to Greek and Spanish debt. Rates will continue to rise. Credit standards will continue to tighten, thus not allowing consumers to purchase goods on credit, and subsequently driving the recovery straight into the ground. In my opinion, banks should not be anywhere near as exposed to such risky loans as they are today. Banks should not be out to make profits solely for themselves, they should be assisting consumers in purchasing and financing their lives. Consumption makes of 2/3s of the economy and if it continues to drop at the hands of these banks, well SPX 666, here we come again. In my opinion, I would buy the larger banks like Deutsche and Commerzbank, since they are less likely to see dramatic results from the tests, in a negative fashion. However, shorting smaller banks might be a good idea, since they have a reduced amount of assets and could see a larger impact for a default or double dip.


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