Bank solvency still the issue as collateral required for interbank loans

The Financial Times carried an article on interbank lending in the Eurozone.  As predicted under the FDR Framework, in the absence of disclosure so that banks can determine if a bank counter-party is solvent, interbank loans now need to be fully collateralized by a risk-free asset.

Interbank lending using European government bonds as collateral has reached record levels, in spite of worries over Greek debt default and the future of the eurozone. 

By contrast, lending between banks without the backing of collateral has ground to a near standstill for any loans of more than a week’s duration, as fears of bank insolvency rise due to continuing uncertainty over Greece and its emergency loan payments. 

Lending using collateral, which is also backed by a clearing house, ensures that a bank will get at least some of its money back in the event of a failure of the bank it has offered loans to. 

In Europe, this form of short-term repurchase, or repo, lending hit daily highs of more than €220bn ($320bn) last week, as measured by the 20-day moving average – surpassing records set before the financial crisis erupted in August 2007 – according to Icap’s BrokerTec, the region’s leading electronic trading platform. 

This trend towards collateralised lending, which is cleared through LCH.Clearnet, began at the start of the financial crisis in 2007, as banks either hoarded cash or insisted on the backstop of government bonds in return for their money. 

A further example of this trend can now be found in the sterling overnight lending markets. 

Lending in the Repurchase Overnight Index Average, or Ronia, market – which is backed by gilts – has consistently seen larger volumes than those for unsecured lending in the Sterling Overnight Index Average, or Sonia, market this year. 

Last week, lending in the European collateral-backed repo markets surpassed its previous daily peak, which was recorded in July 2007 – a month before the onset of the credit crunch, which forced the European Central Bank to pump nearly €100bn into the financial system to prevent it seizing up.