European Banking System Nearing Collapse

Renewed worries over Europe's debt crisis are bringing us closer to another recession

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European Banking System Nearing Collapse

A Return to 2008

First take a look at the Euribor-OIS swap (the spread between the Euro Interbank Offered Rate and the Overnight Indexed Swap). This swap, widely regarded as a gauge of fear in the European banking system, is at levels we haven’t seen since April 2009 and is rapidly climbing toward levels we experienced during 2008 at the height of the financial crisis.

These rates, along with the London Interbank Offered Rate (LIBOR), represent a sort of feedback mechanism similar to the body’s circulatory system. If the system goes into “shock,” there will be a negative, self-sustaining reaction.

At the same time, shorter-term euro basis swaps have fallen to the lowest levels we’ve seen since Lehman Bros. blew up.

The premium that European banks are paying to borrow in dollars through the swaps market is at its most extreme level since the credit crisis of 2008. The cost of converting euro-based payments into dollars as measured by the three-month cross-currency basis swap fell as much as 93 basis points below the Euro Interbank Offered Rate (Euribor), indicating a higher premium to buy dollars.

Historically, anything in the neighborhood of -150 basis points suggests imminent bank failure.

European Banks A Recipefor Disaster European Banking System Nearing Collapse

Meanwhile, funds parked in the ECB’s “deposit facility” are rising, which means they aren’t being lent to other banks. Funds at the ECB deposit facility hit their highest level — $209.3 billion (145.2 billion euros) — earlier this month. And ECB data shows commercial banks parked $154.4 billion (107.2 billion euros) in the central bank’s deposit facility last Friday, up from $130.5 billion (90.5 billion euros) on Thursday.

This suggests banks are more concerned with having liquidity available to them via “official” sources rather than the open markets.

There are two reasons they would feel that way:

  1. Because they can’t get it from other sources.
  2. And because they don’t trust the other banks who would otherwise serve as their counter party.

Remember, banks only make 0.75% on their deposits at the ECB, which is a smaller return than what they’d receive by lending to other banks. This suggests banks value the return of their money more than the return on their money.

This happened before, most recently in Japan in the 1990s. I remember living in Japan at that time, and things got so bad that the spreads on overnight deposits actually went negative for short periods. That is, Japanese banks actually paid the Bank of Japan to hold their money because they were scared to hold it themselves.

Finally, non-U.S. bank reserves on deposit at the Federal Reserve declined from $900 billion on July 13 to $758 billion as of Aug. 3. I’ve done some calling around and heard from two confidential sources that the level may have fallen as low as $500 billion this week, which would be a near-50% drop in only weeks.

According to the Fed, foreign banking institutions hold approximately 25% of all commercial banking assets in the United States. That makes me think EU banks are calling money home not because they want to but because they need to.


Article printed from InvestorPlace Media, http://investorplace.com/2011/08/european-banking-system-on-the-verge-of-collapse/.

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