A couple of indicators in the market are being interpreted by some as suggesting that we are heading for another liquidity crunch, of the kind observed in the last quarter of 2008 following the collapse of Lehman. That crunch pre-faced a worldwide recession. How serious is the risk of a repeat occurrence?
Let’s take the indicators first. 'Exhibit 1 for the prosecution' is the EONIA-EURIBOR interest rate spread. This is the difference between the euro overnight interest rate and the 3-month interest rate, and its magnitude is an indicator of the health of interbank lending.
Following the Lehman collapse, this spread stood at over 110 basis points. A few months ago it was at around 20 bps, but just recently, amid all the volatility and negative sentiment on both sides of the Atlantic, it has widened out to over 55 bps.
'Exhibit 2' is the commercial paper (CP) and Libor spread. Normally, CP interest rates lie below Libor, the official interbank lending rate, reflecting its liquidity value as a tradeable product compared to a bank deposit. But this week the CP curve has traded above the Libor curve (for instance, in USD the 1-mo CP rate is 29 bps compared to 1-mo Libor of 22 bps).
In theory this would suggest a greater credit risk associated with those banks now borrowing via CP, but for a 1-month tenor it isn’t the credit risk, this spread widening indicates a higher perceived bank funding risk.
So are we heading for a repeat of the post-Lehman experience? In the current environment there is little appetite for complacency or soothing words urging the market not to panic, although conversely doom-mongering often ends up as a self-fulfilling prophecy.
There is little doubt that a serious credit event, such as a Greek sovereign default, would have a severe knock-on effect on the interbank market, not least because in one respect the circumstances would be very similar to the 2007 sub-prime crisis or the 2008 Lehman default: banks are not completely sure exactly who is exposed and to what extent. So they will shorten and/or pull lending lines to other banks.
The immediate impact of a catastrophe event like that would be very messy. So we can expect liquidity stress in the market certainly, and for banks that are still overly reliant on short-term unsecured wholesale market funding it will be painful.
That said, the defense still has a few cards up its sleeve. The big dissimilarity with 2008 is that markets are much more pessimistic anyway, and a catastrophe event such as a sovereign default would not be entirely unexpected.
Secondly, banks have learned the lessons of 2008 and have termed out much of their borrowing, and reduced their reliance on the interbank market by dint of greater use of secured ('repo') funding.
Thirdly, central banks have gone to considerable lengths to preserve interbank liquidity, with various measures that have included lowering eligibility criteria to obtain central bank funding. So ultimately while we can certainly expect continued volatility and harsher interbank conditions, we should not necessarily expect a repeat of the 2008 experience.
Of course in the current environment, there is very little for the market to be positive about, which is why the gold priceis hovering at the $2000 mark. If it is touching $2500 by year’s end, this will tell us all we need to know about market sentiment. It is such negative sentiment that will drive market participants’ behavior, not cold logic, which is why it makes sense to view the threat of another liquidity crunch as real.
Time perhaps for the European Central Bank to restore its 1-year repo funding facility? And yes, time for some more positive economic statistics!
The author thanks Nayan Sthanakiya at RBS Global Banking & Markets for assistance with this article
Moorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University.