Europe’s Banks Hint at Return to Health

Europe’s banking system is returning to health amid signs that financial institutions are no longer hoarding cash, according to key indicators.

European Central Bank
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European Central Bank

Euro overnight bank lending rates have “normalized”, while banks have scaled back the amount of money held at the European Central Bank above reserve requirements – known as excess liquidity.

This has raised hopes that institutions are lending to each other again as fears of counterpar ty risk and a deepening of the euro zone debt crisis recede.

Jürgen Stark, executive board member of the ECB, pointed to “an improvement in the market situation” in a speech last week.

A sustained improvement in market conditions could see the ECB speed up its exit strategy from exceptional policy measures, introduced after the collapse of Lehman Brothers in 2008, of offering unlimited loans to euro zone banks.

Euro overnight lending rates – the rates banks charge each other for loans known as Eonia – have jumped above official ECB interest rates of 1 percent for the first time since June 2009, while excess liquidity fell to €7 billion ($9.5 billion) last week from €350 billion at its peak last June.

The ECB, which holds its next interest rate setting meeting on Thursday, will see the rise in Eonia rates as a positive, highlighting the gradual return of confidence in euro zone banks.

Don Smith, economist at Icap, said: “Confidence has improved in the eurozone banking system as things are normalising. This could be a sign that banks are lending to each other again.”

However, he cautioned that market sentiment could quickly turn, while other strategists have pointed out that many banks based in Greece, Ireland and Portugal remain shut out of the lending markets and reliant on ECB loans.

In so-called normal markets before the financial crisis, Eonia overnight rates would typically fluctuate around the ECB’s official lending rate, while there was little excess liquidity in the system.

However, since the collapse of Lehman, Eonia rates have been forced much lower than official rates as they have been depressed by the excess liquidity as many banks have hoarded cash at the ECB.

The ECB has already started to unwind its exceptional policy measures. It has stopped providing unlimited liquidity on a 12-month and six-month basis, but the “exit strategy” was shelved last year with the escalation of the debt crisis.

The next steps are likely to be decided at the ECB’s March governing council meeting, after which it will announce a liquidity regime for the second quarter of 2011.