Eurozone banks face funding stress as the question of who is solvent and who is not re-emerges

A Wall Street Journal article describes the steps that Eurozone banks are taking to secure funding as the inter-bank lending market freezes over.

This was both predictable and avoidable.

It was predictable because policymakers and financial regulators have not required each bank to disclose on an on-going basis its current asset, liability and off-balance sheet exposure detail.  As a result, market participants do not have the data to assess who is solvent and who is insolvent.

Without an answer to that question, banks are naturally reluctant to lend to each other.

It was avoidable if current detail disclosure had been required.

Instead, Eurozone banks are relying on a financing technique that increases the fragility of the financial system.

Update


Previously, I presented a blueprint for saving the European financial system.  At the heart of the blueprint was current detail disclosure.

One of the benefits of this type of disclosure is that it supports the ability of the ECB to lend against a wider range of assets.  Specifically, it lets the ECB extend its lending from covered bonds and asset-backed securities to whole loan portfolios.

In short, the ECB can take as collateral all the assets held by a bank.  When combined with the European Financial Stability Fund and national governments guaranteeing deposits, this means that Eurozone banks can continue to function even if they have significant negative book capital for a number of years.

European banks, increasingly concerned about their ability to access funding, are devising complex and potentially risky new deals that enable them to continue borrowing from the European Central Bank. 

The banks' maneuvers, which include behind-the-scenes swapping of assets among financial institutions, could heighten risk across Europe's already fragile financial system, say some senior industry officials and regulators. 

They also are a sign that struggling banks across Europe are preparing for a period of prolonged reliance on financial lifelines from the ECB. 

The Continent's intensifying financial crisis has made it difficult for many banks to obtain funding from customary market sources. 

Some banks are exhausting their supplies of assets—such as European government bonds and certain types of asset-backed securities—that the ECB accepts as collateral and that the banks haven't already committed to other uses, according to bankers and analysts. 

Others are scrambling to stockpile such assets to comfort analysts and investors worried about the banks' abilities to weather a long-term freeze in bank-funding markets....

And some European bank customers are balking at doing business with the banks.... 

To ensure that their access to ECB loans continues, the banks are entering into a variety of complex transactions with other financial institutions to come up with billions of euros worth of assets that they can pledge as collateral to secure ECB loans, according to bankers and industry officials. 

Some regulators and bankers are worried. By transferring potentially risky assets among a wide range of institutions, the so-called liquidity swaps have the potential to "create a transmission mechanism by which systemic risk across the financial system may be exacerbated," the U.K.'s Financial Services Authority warned in a July consultation paper... 

The scramble for ECB-eligible collateral highlights the tenuous state of Europe's banking industry. Traditional sources of bank funding, including institutional investors and fellow banks, have largely fled amid concerns that many lenders are sitting on huge piles of risky government bonds and loans to shaky borrowers....

It is exactly this concern that current detail disclosure addresses.

In the increasingly popular liquidity swap, banks transfer illiquid assets such as non-investment-grade loans to corporations or to finance public-infrastructure projects—and which aren't eligible to serve as collateral for ECB loans—to investment banks or insurance companies. 

In return, the investment banks or insurers provide government bonds or other liquid assets that the original bank can use as collateral to secure loans from the ECB. 

The investment banks apply a discount to the assets they are receiving—shielding them from some potential losses—and receive commissions on the trades.... 

A number of French, Italian and other European banks, including bailed-out Franco-Belgian lender Dexia SA, recently have entered into such transactions, according to people familiar with the matter.

"It's a way to improve your liquidity and to get liquid some assets that are not liquid," said a senior Dexia executive, who says he has crafted billions of euros of such trades in recent months. 

The Frankfurt-based central bank accepts a wide variety of assets as loan collateral, including European sovereign bonds, securities comprised of mortgages and other assets, and "covered bonds" backed by loans and other assets on banks' balance sheets. 

The ECB's extensive loans to banks have put its own balance sheet at risk, many analysts say. 

Partly to protect banks in the periphery, ECB officials suspended rules that had confined the central bank to only accepting investment-grade government bonds. As a result, the ECB now holds junk-rated Greek, Irish and Portuguese bonds. 

ECB officials insist their balance sheet is safe. The central bank has taken steps to protect itself, including doubling its capital base. 

At the end of October, euro-zone banks had borrowed a total of nearly €600 billion ($811 billion) from the ECB, up from €495 billion at the start of the year, according to data from individual central banks. 

Among the biggest borrowers are banks in France and Italy, with each country's sector having borrowed a total of more than €100 billion at the end of September, up sharply from prior months. 

At giant French bank Crédit Agricole SA, executives said last week that they are taking steps to "rapidly increase" their holdings of assets that can be pledged as collateral. Among those actions are bundling together large numbers of mortgages and other loans into asset-backed securities that the ECB will accept, according to a person familiar with the matter. 

Some executives are pleading with the ECB to accept a wider array of assets. "In the name of the smallest Italian banks, I will ask [the ECB] to look into the possibility to broaden access to ECB liquidity by expanding the type of collateral offered," UniCredit SpA Chief Executive Federico Ghizzoni told an Italian newspaper Wednesday. 

For months, European banks have been pursuing innovative strategies to address their real or perceived collateral shortages. Several Greek banks, for example, recently issued government-backed bonds that analysts say are likely to serve as collateral for ECB borrowings.