Central bank action will not stem Eurozone debt crisis

Posted on : Thu, 22 Sept 2011

Central banks have pledged to provide European banks with access to dollars to mitigate the impact of the Eurozone debt crisis on bank lending. However, the move will only provide short-term relief and QNB Capital argues that more needs to be done to protect banks and address the underlying debt crisis.

The European Central Bank (ECB), in coordination with central banks in the US, Japan, UK and Switzerland, announced on 15th September that it will conduct three US dollar liquidity-providing operations, lending dollars at around 1% interest for 84 day periods. The liquidity operations are scheduled for 12th October 2011, 8th November 2011 and 7th December 2011. These operations will extend the existing arrangement which provides dollar liquidity for a period of seven days. The measures mean that European banks will have access to dollar funds, limited only by their eligible collateral, according to QNB Capital.

The measure was designed to address short term dollar funding concerns about a shortage of dollars amongst European banks. There had been persistent rumours that US financial institutions were reluctant to lend US dollar funds to a number of European banks. The central banks’ move should ensure that European banks have easier access to dollar funds until early 2012. Also the banks will not be forced to sell their dollar assets at sharp discounts to meet liquidity requirements.

Consequently, the move initially led to a positive response from global markets, sparking a rally in European stockmarkets and reversing the recent downward trend in the value of the euro against the dollar. The Euro Stoxx 50 index, which tracks the top 50 companies within the Eurozone, gained 3.5% on the day of the announcement and the euro gained 1.0% against the dollar. European banks also made strong gains with BNP Paribas rising more than 20% and Credit Agricole, Societe General, UniCredit, Intesa Sanpaolo all rising around 10%.

Similar dollar liquidity arrangements were put in place during the peak of the financial crisis in late 2008, when banks were totally cut off from other sources of dollar funding. At that time there was a strong appetite amongst European banks for the liquidity provided through ECB facilities.
However, currently banks have not been utilising the existing ECB seven-day dollar liquidity facilities to a large extent. Only US$575m was borrowed from the ECB by Eurozone banks for the week from 15th September, despite the intense pressure on dollar funding. The central bank measures are therefore a precautionary step that will shore up and insulate the banking system in case of a sovereign default in Europe rather than an emergency response to immediate dollar funding requirements, according to QNB Capital.

While the central banks’ intervention is impressive in its display of commitment and global cooperation, it does not address the longer term funding issues of banks. Concerns remain regarding the ability of European banks to withstand a sovereign debt default or restructuring. This explains why investor worries about the growing likelihood of a Greek default quickly reversed the stockmarket and euro gains that followed the central bank announcements.

European banks lost most of their gains on 16th September, the day following the ECB announcement, with Credit Agricole falling 11%, BNP Paribas 8% and UniCredit 7%. Stronger measures are therefore needed to fully satisfy markets that banks have the required resilience to weather a sovereign default. Such measures might include a credible guarantee of bank debt or capital injections directly into banks.

More needs to be done to directly address Europe’s sovereign debt issues, which are the root cause of the problem. This could involve cutting ECB interest rates, creating Eurobonds backed by all Eurozone countries, expanding the ECB’s Italian and Spanish bond-buying programme, or moving towards greater fiscal union in the Eurozone. The three former measures would help drive down borrowing costs for some of the indebted countries, but this would only be a short-term solution, giving these countries breathing space to reform their fiscal situations.

Therefore, despite the increased accessibility to dollar liquidity provided by the world’s central banks, QNB Capital maintains that the move does little to address the underlying concern about the ability of European banks to withstand a sovereign debt default. Until this is more directly addressed, bank’s appetite for lending and investment will remain restrained. Both BNP Paribas and Societe Generale have already announced plans to shrink their balance sheets by about 10%.