The worrying decline of the unsecured interbank market June 18, 2012 at 9:35 am
Benoît Cœuré, Member of the Executive Board of the ECB, recently gave an important speech. It has quite a lot in it so even the bullet point version isn’t that short, but I promise you that it is worth thinking about his essential argument.
- Money markets around the world came under severe stress during the recent financial crisis and in the subsequent sovereign debt crisis, with interest rate spreads jumping to unprecedented levels and market activity declining significantly in many market segments.
- Opacity in banks’ balance sheets, coupled with uncertainty about the real valuation of their assets, led to acute tensions in the markets for credit instruments… Off-balance sheet entities became unable to roll over short-term financing in the US asset-backed commercial paper market. These events reinforced each other and generated uncertainty about both the solvency and liquidity of money market participants. Counterparties could not distinguish good banks from bad.
- Liquidity was no longer flowing from cash-rich banks to cash-poor banks.
- The Eurosystem introduced a fixed-rate full allotment regime in its refinancing operations, offering unlimited liquidity to banks at predictable cost against an expanded set of eligible collateral. The rise in the liquidity deposited with the Eurosystem after October 2008 was a direct consequence of this new regime and a symptom of a malfunctioning money market.
- Stress in the Euro unsecured money market continued beyond 2008, with a reduced turnover and preference for lending at shorter maturities.
- Dispersion in banks’ access to funding increased considerably in the euro area, with banks domiciled in countries under sovereign strains facing severe constraints even in obtaining secured funding.
- Deep and liquid money markets, not unlike other markets in the economy, play an important part in information aggregation and price discovery. They also help to ensure market discipline.
- Money markets play a central role in monetary policy transmission in the euro area.
- It is important that the Basel 3’s new liquidity regulations do not hamper the functioning of funding markets. This applies in particular to the calibration of the run-off rates for interbank funding and to the asymmetrical treatment of liquidity facilities extended to financial firms.
- The regulators’ welcome push to OTC derivatives towards CCPs may also have an effect on both the unsecured and secured money market segments. Such a move will lead to an increased need for high-quality collateral. The supply of safe assets is finite and the pool of “good” collateral is dwindling as the creditworthiness of certain sovereigns is questioned by market participants. The more good collateral is pledged to the CCPs, the less is left to use in the secured money market, and the fewer assets are available to other creditors in the event of default, making it difficult to obtain unsecured refinancing. This strengthens the need to find ways to identify or produce new assets that can be used as collateral and to mitigate the pro-cyclical consequences of credit ratings and of market valuation.