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Central Banks Pushed to Act as Funding Squeeze on Banks Worsens

ECB President Mario Draghi
ECB President Mario Draghi has resisted pressure from politicians to backstop governments as contagion spreads to Italy and France, confronting leaders with what Morgan Stanley calls a “critical moment in European history.” Photographer: Hannelore Foerster/Bloomberg

The squeeze that has driven funding costs for European banks to the highest since the aftermath of Lehman Brothers Holding Inc.’s collapse is prompting economists and traders to urge central banks to do more to fight the worsening debt crisis.

The Euribor-OIS spread, a measure of banks’ willingness to lend to each other, widened to 98.2 basis points at 9:15 a.m. in London, the biggest gap since March 2009, up from 96.6 basis points yesterday. The cost for European banks to fund in dollars rose to the highest level since October 2008, a month after New York-based Lehman filed for bankruptcy protection.

European Central Bank President Mario Draghi has resisted pressure from politicians to backstop governments as contagion spreads to Italy and France, confronting leaders with what Morgan Stanley calls a “critical moment in European history.” While the ECB is already offering banks unlimited cash and has cooperated with the Federal Reserve to keep dollars flowing through the financial system, other options may include cutting its benchmark interest rate, expanding liquidity lines or working with the International Monetary Fund.

“We’re in this vicious circle in the European financial system,” said Jim O’Neill, the London-based chairman of Goldman Sachs Asset Management. “Somebody has got to take us out of it soon.”

Swap Rate

The three-month cross-currency basis swap, the rate banks pay to convert euros into dollars, was 159 basis points below the euro interbank offered rate in London, compared with minus 157 yesterday. The gap has widened from as little as minus 8 basis points on May 4.

European leaders are split over the ECB’s role in the spiraling debt crisis. The bank, backed by a German-led bloc, refuses to do more than buy a limited amount of troubled countries’ bonds in the market. France has called for the ECB to grant the euro bailout fund a banking license to enable it to borrow unlimited amounts.

Euro-area finance ministers meeting in Brussels yesterday said they would seek a greater role for the IMF in fighting the crisis, which could make it easier for the ECB to play a bigger role, possibly by channeling loans through the Washington-based institution.

With leaders showing no signs of reaching a breakthrough, investors are refusing to lend the cheap liquidity handed out by the ECB. Banks yesterday increased overnight deposits at the ECB, placing 297 billion euros ($394 billion) with the Frankfurt-based central bank, up from 281 billion euros on Nov 28.

‘Lack of Trust’

“We have year-end money demand, we have a sovereign debt crisis, and a banking crisis,” said Christoph Rieger, head of fixed-income strategy at Commerzbank AG in Frankfurt. “They are all coming together. There’s general lack of trust still, especially in the dollar market.”

U.S. financial institutions are pulling their money back from Europe. In October, prime money-market funds cut holdings of European bank debt to the lowest since at least 2006, reducing them by 9 percent on a dollar basis, Fitch Ratings said on Nov. 22. The 10 biggest funds had 34.9 percent of their $642 billion of total investments in European bank bonds and notes, down from 37.7 percent as of end-September.

Banks are struggling to get access to dollars even after the ECB said Sept. 15 it will coordinate with the Federal Reserve and other central banks to lend dollars to euro-area banks in a series of three-month loans. Just $400 million was allotted in the last three-month auction on Nov. 9. Those loans are in addition to the bank’s regular seven-day dollar offerings.

“Dollar liquidity is being held in the U.S. by money market funds and until they” start lending little can be done, said Patrick Jacq, a senior fixed-income strategist at BNP Paribas SA in Paris. “The ECB is providing dollars to European banks but so far there has not been much demand because the cost is expensive.”

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