Four years to the month since the global credit crisis began, the European Central Bank has emerged as the lender of first resort to the Continent’s broken banks. With the bond market shut off to all but the strongest lenders, the ECB’s unlimited loans are keeping the most afflicted banks in Greece, Portugal, Italy, and Spain afloat. “Banks are becoming more nervous about being exposed to other banks as they hoard liquidity and become more suspicious of other banks’ balance sheets,” Guillaume Tiberghien, an analyst at Exane BNP Paribas, wrote in a note to clients on Aug. 19.
On that date, banks deposited €105.9 billion ($152 billion) with the ECB overnight, almost three times this year’s average, rather than lend the money to other banks. They are also stockpiling dollars and hoarding cash in safe havens such as Swiss francs. “I’m not sleeping at night,” says Charles Wyplosz, director of the Geneva-based International Center for Money and Banking Studies. “We have moved into a new phase of crisis.”
Investors are concerned, too. The price of European bank stocks sank 22 percent between Aug. 1 and Aug. 22, led by Royal Bank of Scotland (down 45 percent) and France’s Société Générale (down 39 percent). The extra yield investors demand to buy bank bonds instead of benchmark government debt surged to 2.98 percentage points on Aug. 19, the highest since July 2009, data compiled by Bank of America Merrill Lynch show.
Despite the ECB’s best efforts, some of Europe’s banks may be inching toward insolvency. The cost of insuring the bonds of 25 European banks and insurers set a record high on Aug. 24 of 257 basis points, higher than the 149 basis-point spike when Lehman Brothers collapsed in the fall of 2008, according to the Markit iTraxx Financial Index of credit default swaps. The banks aren’t required to mark down most of their holdings of government debt to market prices. If they did, some would be forced to default or seek a bailout.
Morgan Stanley estimates that Europe’s banks need to raise €80 billion by yearend. Their ability to raise capital has been sharply curbed by investor fears. Banks in the region hold €98.2 billion of Greek sovereign debt, €317 billion of Italian government debt, and about €280 billion of Spanish bonds, according to European Banking Authority data.
The Federal Reserve, which provided as much as $1.2 trillion of loans to banks in December 2008, wound down most of its emergency programs by early 2010. One of the few exceptions is the central bank liquidity swap lines that provide dollars to the ECB and other central banks, so they can auction off the dollars to banks in their own jurisdictions.
In contrast, the ECB and its president, Jean-Claude Trichet, are still in the bank-rescuing business. “The central bank is the only clearer left to settle funds between banks,” says Christoph Rieger, head of fixed-income strategy at Commerzbank in Frankfurt. After increasing its benchmark rate twice this year to counter inflation, the ECB in August provided relief for banks by buying Italian and Spanish bonds for the first time, lending unlimited funds for six months and even providing one unnamed bank with badly needed dollars.
The ECB is maintaining a role it began in August 2007 when it injected cash into markets after they froze. The ECB’s balance sheet is now 73 percent bigger than in August 2007, and its latest round of bond buying has opened it to accusations that by rescuing profligate nations it’s breaking a rule of the euro’s founding treaty and undermining its credibility. The central bank is acting in part because governments have yet to ratify a plan to extend the scope of a €440 billion rescue facility so it can buy sovereign bonds on the open market, which would allow governments to inject capital into the banks. Although the euro zone member governments are supposed to approve the new funding by fall, no one can say for sure.
The funding difficulties of Europe’s banks is one reason cited by Morgan Stanley economists on Aug. 17 for cutting their forecast for euro-area growth to 0.5 percent next year, less than half the 1.2 percent previously anticipated. Europe’s consumers and companies are more reliant on banks for funding than their U.S. counterparts, says Tobias Blattner, a former ECB economist now at Daiwa Capital Markets Europe in London.
Lena Komileva, Group of 10 strategy head at Brown Brothers Harriman in London, says the ECB may have no option but to extend the backstop role it is playing. Refusal to do so would risk a European bank default by the end of the year, she says: “Markets are back in uncharted territory. The crisis is a whole new story now.”