If you live in San Francisco you get used to the tremors. In banking, however, every shake and jerk still feels like it might herald another devastating earthquake. Investors are nervous and regulators are too. Monitoring risk in the financial system was once a job for officials thought to be too dull for monetary policy. Now financial seismology is where it’s all at, The Economist reported.
When all three of the most-watched gauges of stability in banking deteriorate, as they did in Europe in the last week of May, there is naturally a rush to sound the alarm. Nerves had already been frayed by the Bank of Spain’s seizure of CajaSur, a savings bank, on May 22nd (despite the central bank’s efforts to telegraph this for months). Ratings downgrades of assets guaranteed by Spain’s central bank didn’t help either. The first of these unsettling gauges is the rate at which banks are willing to lend to one another, known as LIBOR (London Interbank Offered Rate). As of June 2nd the three-month dollar LIBOR rate had more than doubled to above 0.5%, a level last seen a year ago, after lounging comfortably for months at about 0.25%. The second alarm is the widening in the spread between LIBOR and the relatively risk-free interest rate known as OIS (overnight indexed swap). In May it tripled to above 0.3 percentage points, suggesting that banks are hoarding cash rather than making it available on the interbank market. The final signal is in the credit-default swaps (CDS) market, a measure of the price paid to insure debt issued. CDS spreads on even the biggest banks have also surged in recent days (see chart), indicating the risk of default, while low, has risen. For a few smaller European banks these spreads are at scary levels.
The financial system has been strained, but it has not broken down.
That partly reflects the extraordinary help that the European Central Bank and other central banks are still offering. The ECB is providing at least €800 billion in loans to banks, much of it in exchange for slightly soiled government bonds and other dubious assets. Part of the funding jitters reflects the remote but higher risk that the government of a big European economy, such as Spain, might default. This would be a calamity for European banks. But the nervousness also reflects the widespread belief that European banks have been slow to recognise losses on private-sector assets.
The numbers are certainly large. The ECB recently estimated that euro-zone banks would take €123 billion of charges against loans this year. However, it reckoned this might be partly offset by profits from securities whose prices are recovering. And, in any case, that figure needs to be put in the context of a very big banking industry, with a lot of underlying profits, especially when compared with America’s. In 2009 euro-zone banks absorbed similar bad-debt costs to those expected this year while still making a net profit, and thus replenishing capital. Read more.
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