Two weeks ago we noted [17] the transmission channels that Mr. Draghi had pointed out having become broken, clearly enunciating the chasm that is developing in the interbank market. Goldman's Huw Pill takes this a step further and notes a 'red line' - running along the Pyrenees and the Alps - that has descended with banks south of this line having difficulty accessing Euro interbank markets, whereas banks north of that line remain better integrated and retain market access. This is the exact segmentation that Draghi worries is interfering with policy transmission (and thus affecting macroeconomic outcomes - in his view). Banks in the periphery have been 'red-lined' and while last week's ECB announcements initiated a policy response to this segmentation, the obvious (to anyone who actually comprehends the situation) reality is that ECB purchases of government bonds does not eliminate this 'red line'; only convincing markets through fundamental adjustment (fiscal consolidation, structural reform, and institutional building) will the red-line be lifted. This is highly improbable in the short-term and means an expectation of more direct intervention in bank funding markets (with all its encumbrance) will occur soon enough.
Goldman Sachs: Focus: Europe’s ‘red line’: Segmentation of the Euro interbank market is significant
Bottom line: A ‘red line’ has descended across Europe, running along the Pyrenees and the Alps. Banks south of this line have difficulty accessing Euro interbank markets, whereas banks north of that line remain better integrated and retain market access. As Mr. Draghi emphasised at last week’s ECB press conference, this segmentation is interfering with monetary policy transmission and thus affecting macroeconomic outcomes. Monitoring the intensity and geographical location of the ‘red line’ will remain crucial going forward, not least to assess the effectiveness of the policy measures announced by the ECB last week.
“… financial fragmentation hinders the effective working of monetary policy”. Mr. Draghi’s comments at last week’s ECB press conference have placed the segmentation of Euro financial markets at centre stage. In this daily, we explore the nature of that fragmentation, focusing on the Euro interbank markets.
Documenting the segmentation of the Euro interbank market. To explore this phenomenon, we compare cross-border lending before and after the onset of financial crisis using data from the Bank for International Settlements (BIS).
We use the BIS consolidated banking statistics. For each Euro area country, these data provide the foreign claims of domestic banks, broken down by the counterparty country. The data are gross insofar as intra-country positions are not netted out, but consolidated insofar as all branches and subsidiaries of banks are included in the figures for the country of the head office.
This treatment of foreign banks means that, for example, a loan from a German bank’s subsidiary in France to a French resident is treated as a German asset. As such, these data do not correspond to the ECB monetary statistics, which are our usual benchmark. Nonetheless, assuming no large changes in the activity of subsidiaries between the two periods we examine, this should not bias our analysis. Indeed, one could argue that foreign subsidiaries' loans to domestic residents also represent an important form of cross-border activity that should be captured when coming to an assessment of market integration.
From hot to cold: The periphery is being frozen out. Charts 1 and 2 show the row country’s bank claims on the column country’s banks, in 2008 Q1 and 2012 Q1 respectively. The numbers capture these claims expressed as a percentage of the column country’s (quarterly) GDP in 2008 Q1. Of course, representing the data in this form is not a neutral choice. But the basic insights revealed are not sensitive to our choice of scaling variable.
The charts are presented in the form of heat maps: ‘hot’ colours (red) reflect a high degree of financial interaction, whereas ‘cold’ colours (blue) point to financial isolation.
In 2008 Q1 before the failure of Lehman, integration of Euro interbank markets was high: i.e. Chart 1 is predominantly red. With the notable exception of Greece, banks in all Euro area countries have significant claims on all other Euro area countries. Ireland, Spain and Italy are all well-embedded into the Euro interbank markets.
[18]
In 2012 Q1 as the European sovereign crisis has intensified, integration has broken down: i.e. Chart 2 is predominantly blue. In particular, the three programme countries (Greece, Portugal and Ireland) have become isolated. Spain (and to a lesser extent Italy) are also drifting towards greater isolation, whereas among Germany, France and the Netherlands integration remains significant, albeit still diminishing.
[19]
A ‘red line’ has emerged in Euro interbank markets – and is shifting northwards. To draw on the credit rationing literature in economics, banks in the periphery have been “red-lined”, i.e. simply on account of their residency, they are being excluded from the Euro interbank markets.
This red line has long isolated the program countries. And it is now moving northwards: Italy and (especially) Spain are vulnerable. A ‘red line’ running along the Pyrenees and Alps cleaves the big-4 countries at the heart of the Euro area in two. Given the deep recessions being suffered in Spain and Italy, the implications for borrowers and the real economy – as well as for the ability of monetary policy to ease tight financing conditions – are self-evident.
Last week’s ECB announcements initiate a policy response to this segmentation. But ECB purchases of government debt in and of themselves will not eliminate the ‘red line’. Rather, rebuilding the confidence of international investors and northern European asset managers in the economies of the periphery and the sustainability (or “irreversibility” as Mr. Draghi has styled it) of their membership of the Euro area is crucial. This is where underlying macroeconomic adjustment – the fiscal consolidation, structural reform and institution building mentioned in last week’s ECB statement – are key.
But convincing the markets through fundamental adjustment takes time. Meanwhile, we may need to see more direct action by the ECB to breach the 'red line' dividing Europe's banks so as to support credit conditions and growth in the periphery. Our analysis here therefore offers further reason to believe that the ECB will intervene more directly in bank funding markets, as we suggested last week.
Source: Goldman Sachs