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.

4 Responses to “The worrying decline of the unsecured interbank market”

  1. Good speech. Good to read someone speaking about the important of unsecured markets in terms of allowing for true price discovery.

    What I find strange is the argument that there needs to be less heterogeneity in capital ratios of banks, to make the interbank market work better. Surely heterogeneity is irrelevant – if the interbank market is working properly, all banks with a capital ratio in excess of its min regulatory requirement should be able to access funding at some price? If quantity rationing kicks in at some level of capitalisation, that’s a diagnostic of a market that can’t price all risks, surely?

  2. QM – exactly, or at least it would be if reg cap was doing its job. A key design principle in reg cap should be

    Is this level of capital enough to ensure that the bank always has the confidence of the funding markets?

    Sadly, current rules don’t meet that test, which is why their funding costs are so high despite supposedly being well capitalized.

  3. Well capitalised and very very highly leveraged. Go figure?!

    There will be a challenge for the reg cap regime in convincing markets that the capital required to access funding markets in a downturn should be lower (ie let buffers be buffers, not floors). There is hysterisis in the market-required minimum, it seems. For a bank trying to deal with that, better to run with capital way in excess of reg minima.

  4. I wish he had proposed his alternative to the current treatment of interbank funding in the LCR. The crisis has shown quite clearly that unsecured interbank funding will drop to zero in a heartbeat for a bank perceived to be weak. I am not sure how giving any credit to this kind of funding would be justified.

    Then again, the ECB came to us a couple weeks ago asking for interbank lending runoff data, so there is obviously some work doing on.