One of the more important stories this week, in addition to the largely underreported collapse in the US foreclosures market courtesy of the Mortgage Mess, was the drop in Eurozone "excess liquidity" when roughly €225 billion in 3,6 and 12 month liquidity providing ECB credit facilities to Eurozone banks expired and were rolled into a far lower amount of replacement maturities: only 64% of the full amount was retendered, meaning about €80 billion in system liquidity was drained. What this means is that the excess liquidity in the eurozone dropped from an already low €100 billion to a paltry €20 billion. Could this be an indication that European banks have bought their own Kool aid as to their stability? If there is another systemic risk flaring episode, and Ireland is most certainly shaping up to be the next Greece and Portugal, just how will banks proceed to raise much needed liquidity, which has dropped from nearly €400 billion in late Q2 2010 to just above zero, and the lowest since the Lehman bankruptcy.
The following charts from JPM shows the dramatic plunge in European banking excess cash:
JPM's observations on this drop in excess liquidity are as follows:
What was the driver of this drain? We believe it was mostly core banks behind this drain, as they decided to simultaneously reduce their borrowing and their deposits with the ECB. As the chart at the top shows, the excess cash of core Euro area banks, has been the driver of the excess cash in the Euro area banking system over the past two years and this core excess cash has likely declined in September to its lowest level since the Lehman bankruptcy. Instead, we expect the borrowing of peripheral banks from the ECB to be flat in September with a potential increase in Irish bank borrowing from the ECB of around €20bn to be offset by a similar decrease in the ECB borrowing by Spanish banks. Spanish banks decreased their reliance on the ECB by €16bn in August, as net bond issuance turned positive and deposits increased. With bond net issuance staying positive in September and Spanish banks continuing to be aggressive in attracting deposits, we expect a similar decline in the Spanish bank borrowing from the ECB in September.
In other words, the weak banks continue to be weak, and have borrowed around €400 billion from the ECB, even as the core healthy banks have either decided they are not concerned by any of the peripheral issues in Europe, or have found another, faster and heretofore unknown direct liquidity providing mechanism from Jean-Claude. We would be very curious to uncover just what it is that has given core European banks so much comfort and confidence that they do not need the excess capital... Unless that excess capital was never needed for backstop purposes but merely for speculation on the outcome of the crisis for the periphery. Which begs the question: was the much maligned "wolfpack" in Europe merely the healthy European banks? JPM sure seems to think so:
Why have core banks chosen to reduce their borrowing from the ECB so sharply this week? The most likely interpretation is that core banks have been borrowing more than they needed from the ECB for speculative purposes, i.e. to invest in bond or interbank markets, and this activity is now less attractive given that long-term funding is no longer available from the ECB. In a way, what happened this week is a repeat of last July when core banks decided to return to the ECB more than €200bn. It is also possible that greater access to interbank and debt capital markets by small core banks might have contributed to the decline in the excess cash.
Well, unfortuantely judging by Euribor, EONIA and EUR Libor, the interbank markets are still as snarled as ever. We only need to remind readers that there is a bank in Europe which for 4 weeks running now has had to renew it weekly $60 million line of credit not from the ECB, but from the FED itself, to replenish its dollar deficiency.
Of course, there is a far more innocuous explanation: merely that core banks have once again started seeing the traditional deposit funding mechanism unlocked.
This week’s collapse in the excess cash in the Euro area banking system is also a reminder that an increase in peripheral bank borrowing from the ECB does not necessarily imply an increase in the excess cash in the Euro area banking system. To see this, let’s assume that depositors move their deposits from peripheral banks, forcing them to borrow from the ECB to replace the lost deposits. Core banks find themselves with extra deposits which they can 1) either deposit with the ECB or invest in bond/interbank markets which also end up with the ECB’s deposit facility, or 2) they can use them to reduce their borrowing from the ECB. The first action causes a rise in the excess cash in the Euro area banking system. But the second action does not cause a rise in the excess cash in the Euro area banking system as increased ECB borrowing from peripheral banks is offset by reduced borrowing by core banks.
Well, that's all great, if only it weren't for one small thing: USDCHF, which closed at a fresh all time low record of 0.9734 (yes, yes, it depends if one uses Bloomberg or another service to track previous record: presumably it dropped lower in March 2008, but for all intents and purposes this is an all time low). If indeed Europeans had regained confidence in their banking system, why does the massive influx in CHF-denominated assets continue?
So what are next steps for European liquidity?
Is this week’s sharp decline in the excess cash sustainable? The availability of unlimited liquidity at the weekly operation combined with this week’s sharp rise in interbank rates, is likely to trigger some speculative borrowing from the ECB over the coming weeks, but this is unlikely to be large. The main lesson from the expiry of the ECB’s long term operations, both this week and last July, is that the withdrawal of long-term ECB funding discourages speculative activity by core banks and this pushes the excess cash in the Euro area banking system to a new lower range, only modestly above zero.
In other words, should there be another ramp in ECB borrowings, it will mean that volatility will increase even as peripheral banks still hold record amount of backstop cash. And if this cash goes to being used as merely collateral for shorting sovereign European bonds, and if this is uncovered, it will likely be the basis of a scandal even larger than when it was discovered than one of the biggest shorters of Greek debt was none other than a Greek bank itself.