ECB Coordinates With Other Central Banks To Provide Liquidity Through Year End

The ECB announced that, in coordination with the Fed, the BOE, the BOJ and the SNB, to conduct 3-month USD liquidity operations for 3 times through the year. In addition to the 7-day USD facility announced on May 10, 2010, the new operation aims to ensure sufficient liquidity in banks. The offerings will be carried out at in the form of repo, at fixed rate and with full allotment. Tender dates will be October 12, November 9 and December 7. The move had sent stocks higher on improved sentiment as central bankers attempted to ease liquidity problems associated to Eurozone's sovereign debt crisis. The euro advanced.

After the collapse of Lehman Brothers in October 2008, the ECB launched the USD liquidity facility in order to meet liquidity demand from the stressed banking system. All operations were discontinued in January 2010 as the funding market improved and demand reduced. However, as the Greek debt crisis began in May 2010, the ECB reactivated the 1-week USD liquidity facility and introduced a special 3-month operation as banks turned more reluctant to lend money to each other again.

The 1-week operation had lacked demand since February this year but a single bidder was reported to have borrowed $500M at a fixed rate of 1.1% on August 18. As we mentioned at that time, this signaled intensified stress in the region's money market conditions. Earlier this week, the ECB said that 2 more banks borrowed a total of $575M via the operation, evidencing rapid deterioration in the banking system in the Eurozone.

Yesterday's announcement marked a step forward to inject liquidity to the market. We believe it would give relief in the short-term but would not help solve the problem. Indeed, we view the move as an indication of the seriousness of deterioration in market sentiment in recent months and world central bankers have envisaged further tightening in the region's banking system going forward. Some market participants said the move was a prelude to the Fed's QE3. We expect the Fed, at next week's meeting' will not deliver anything more than so-called 'operation twist' -increasing the average maturity of securities holdings by swapping holdings of lower maturities Treasuries with longer ones.

European Banks Are Becoming Less Willing To Lend Money, An Early Sign Of Credit Crunch?

News that a European bank borrowed $500M from ECB's 7-day USD funding facility last week intensified concerns in the region's money market conditions. The rise in Euribors, the key euro-prices interbank lending rates, also suggests banks are becoming less willing to lend money to each other. They are also increasingly more suspicious of other banks'balance sheets. Some market participants began to worry about a repeat of the credit crunch in 2008. While it's true that persistence of sovereign debt crisis in the European periphery has deteriorated funding conditions in the 17-nation region, traditional interbank funding rate, LIBOR has been staying well-below the level in 2008, suggesting the current situation is still manageable. However, one should be cautious on further tapping of USD facilities as it would signal a dry-up of liquidity in the banking system.

The ECB disclosed that a single bidder borrowed $500M for a week at a fixed rate of 1.1% on August 18. This is the first time since February 23 that a European bank sought funding using this facility. Usage of the facility has been low as current market rates for banks to obtain USD funding are lower and more flexible. Therefore, the operation is probably treated as the last resort which will only be used when a bank has difficulty elsewhere. The bank's action (share prices suggested that the bank is Société Générale) indicated Eurozone's banking system has been stressed by the prolonged debt problems in peripheral economies.

There are several ways that a European bank can seek USD funding. For the facility mentioned above, the interest rate is expected to be 1-month OIS + 100 bps. While the size is unlimited, the borrowing bank needs to post 12% initial margin. Alternatively, a bank can obtain USD through a USD/EUR cross currency basis swap by funding the euro either through Euribor (around 1.54%) or the ECB repo rate of 1.5%. The total funding costs of using cross-currency basis swap have been less than that through the ECB facility from June 2010 until recently. While the costs of the 3 approaches have converged to very similar levels these days, in normal circumstances, the use cross-currency basis swap is more flexible as it does not require the initial margin of 12%.

Various indicators have shown that banks are increasingly concerned about having exposure in other banks due to suspicion in other banks'balance sheet. The chart below shows that the Euribor-OIS spread soared to the highest level since April 2008 recently, suggesting banks are becoming more reluctant to lend money to each other. The 3-month LIBOR has also picked up, rising to a 6 month high of 0.3117% yesterday.

We tend not to be over worried about the market condition as there's only 1 bank tapping the ECB facility. The amount of $500M was insignificant when compared with $300B in late 2008. However, this acts as an alarm that the interbank market is not functioning well. It's undeniable that widespread concerns about fiscal deficits in some European countries, especially those in the periphery, will continue to drag on bank funding conditions in the region.