What a way to start out the week:
The European Central Bank, the Bank of England and the International Monetary Fund have all recently warned of a looming crunch, especially in Europe, where banks have enough trouble raising money as it is.
Their concern is that banks hungry for refinancing will compete with governments — which also must roll over huge sums — for the bond market’s favor. As a result, credit for business and consumers could become more costly and scarce, with unpleasant consequences for economic growth.
Wow. I didn’t know I could get a S**t Sandwich special first thing on a Monday…
And in case that wasn’t enough, they threw in a menacing chart for emphasis:
And just in case you still didn’t get the message, there’s this quote from the article:
“There is a cliff we are racing toward — it’s huge,” said Richard Barwell, an economist at Royal Bank of Scotland and formerly a senior economist at the Bank of England, Britain’s central bank. “No one seems to be talking about it that much.” But, he added, “it’s of first-order importance for lending and output.”
And so this is where I roll out one of those Minsky charts that illustrates this. Oh, wait:
But why all the fuss over banks being able to roll the debt over? Forget the amount for a second. The key is to look at the average maturity:
A study in November by Moody’s Investors Service found that new bond issues by banks during the past five years matured in an average of 4.7 years — the shortest average in 30 years.
Now why does that matter? It matters because there’s this issue called a maturity mismatch, where the assets and liabilities have different maturities. Usually the assets are longer dated than the liabilities because when a yield curve is upward-sloping like this (from the FT)…
The incentive is to borrow short-dated funds and lend on long-dated assets. I’ve covered this in similar ways before talking about duration hedging in the past where you measure sensitivities to interest rate moves, and this follows in a related vein. When the yield curve inverts, or you have rate shocks at the front-end of the curve, you can find yourself in a precarious position if you have a lot of paper to roll. Which is exactly where a lot of banks are finding themselves now.
But take a look at this section from the article (emphasis mine):
The financing crunch has its origins in a worldwide trend for banks to borrow money for shorter periods.
The practice of short-term borrowing and long-term lending contributed to the near-collapse of the world financial system in late 2008 when short-term financing dried up. Banks suddenly found themselves starved for cash, and some would have collapsed without central bank support.
Government bank guarantees extended in response to the crisis also inadvertently encouraged short-term lending. The guarantees were typically only for several years, and banks issued bonds to match.
So the maturity mismatch issue played a huge role in getting us into this mess, and the government’s response may very well end up in exacerbating the problem.
Brilliant… I might as well go build a house and then torch it myself…
And Tim Backshall has a very interesting chart that shows the spreads between senior bank debt and sovereign are highly correlated and compressing. That means the lines between sovereign and bank debt in Europe are getting blurrier:
One other facet about this problem: the link between external bank funding and Euro Libor:
Bond issuance by financial institutions in Europe plunged to $10.7 billion in May, compared with $106 billion in January and $95 billion in May 2009, according to Dealogic, a data provider. New issues have recovered somewhat since, to $42 billion in June and $19 billion so far in July.
My take: proof positive that the funding crisis for European banks is ongoing and getting worse. How so? Simple. Longer dated bond issuance has fallen, which has led to a change in the maturity profiles of European bank liabilities.
Because the banks are rolling into shorter-dated Libor based funding…
Which has lead to the run-up in the Euro…
One way to mitigate this risk is matched maturity funds transfer pricing – where the asset side of the balance sheet has the same maturity profile your liabilities has. I’m going to leave you with this paper which I also posted on Scribd:
And a link to this post by Don van Deventer at Kamakura, that has some really good ideas on how to implement funds transfer pricing effectively.