ECB Monetary Operations Have Unintended Effects on

UNCLAS FRANKFURT 001684

SIPDIS

DEPARTMENT FOR EUR/AGS
TREASURY FOR LUKAS KOHLER/OFFICE FOR EUROPE AND EURASIA

E.O. 12958: N/A
TAGS: EFIN ECON EU GM
SUBJECT: ECB Monetary Operations Have Unintended Effects on
Interbank Lending Market

ENTIRE TEXT IS SENSITIVE BUT UNCLASSIFIED. NOT FOR INTERNET
DISTRIBUTION


1. Summary. Despite some signs of a return to financial stability
in the euro zone, the dysfunctional state of interbank lending
remains a cause of concern at the European Central Bank (ECB).
Private banks continue to rely on the ECB for liquidity, reflecting
ongoing confidence issues in the banking sector. Seeing no way to
quickly bring the interbank market back to normal, the ECB will
continue to inject liquidity into the market. The ECB recognizes the
possible unintended effect of replacing interbank lending and
thereby delaying a money market recovery. End Summary.


2. In a conversation with Treasury Acting Deputy Assistant
Secretary Eric Meyer and Congen Econ Off, an official in the
European Central Bank Division for Monetary Policy Stance said that
while he saw no impending credit crunch in Europe and no signs of
contagion spreading to the wider economy, he remained concerned
about ongoing dysfunction in interbank lending. Prior to August
2007, European interbank lending rates, as measured by the Euro
Interbank Offered Rate (Euribor),hovered five to ten basis points
above the ECB rate, reflecting trust between counterparts in the
sector. As interbank lending froze up at the start of the turmoil,
the Euribor shot up. To date, it stands approximately eighty basis
points above that of the ECB. While low-risk overnight lending
between banks has returned to normal, the official said that the
market for three-month lending was not working as banks continued to
rely on collateralized ECB monetary operations as a source for
longer-term liquidity.


3. The ECB official pointed out that the Euribor was becoming an
increasingly meaningless measure of interbank lending rates because
the overall number of transactions on which it is based has
drastically decreased. He said that over three hundred banks
currently submitted winning bids for ECB liquidity, but the number
"could be in the thousands" if the central bank increased the volume
of liquidity. He described the bidders as "big, well-established
banks paying over price," whose bids were geared to the Euribor
rate. The continued demand for ECB liquidity suggests that the
actual cost of non-collateralized interbank lending remains higher
than what the Euribor indicates and what banks bid for ECB
liquidity.


4. The official suggested that one contributing factor may be that
ECB monetary operations are confidential, a valuable commodity in an
atmosphere where banks do not trust each other. Yves Mersch, a
governing council member at the ECB, said publicly two weeks ago
that private banks were deliberately handing over low-rated assets
as collateral for ECB liquidity since they are unable to sell these
assets on the open market. The risk to the ECB of holding such
collateral remains low as both the asset and the bank would have to
fail for the central bank to lose money, while the ECB still earns
interest on its operations. However, Mersch worried about a moral
hazard: "We are not in the business of taking over the market.
That means there must be an exit strategy." The ECB official
admitted that banks have repackaged bad assets and given them to the
ECB, thereby converting non-liquid assets into liquid ones.


5. For the ECB official, the greater worry was that the ECB risked
replacing the money market, thus delaying or preventing a return to
normality. However, he saw no way out of the situation saying that
the ECB "did not have the tools to fix the situation." In fact,
since March 2008, the ECB has offered liquidity on even more
attractive terms, including six-month as well as three-month loans.
The official argued that central bank liquidity was only a stop-gap
measure and that the end of the crisis of confidence would only come
when private banks regained trust in one another and resumed normal
levels of interbank lending. A senior economist at Deutsche Bank
told Acting DAS Meyer and Congen Econ Off that he expected permanent
changes in the interbank lending market, with future rates at twenty
basis points above the ECB.


6. Comment. The global financial turmoil that began in August 2007
has had, on the surface, only a limited impact on the euro zone, as
the ECB has staved off an overall credit crunch and prevented
contamination to the economy as a whole. However, the continuing
dysfunction of the money markets remains a concern for the ECB,
especially given the possibility that its own monetary operations
could play a role in forestalling recovery. Central bankers have
acted boldly to stave off a wider crisis, but the unintended
consequences of these actions are only beginning to be apparent.
End Comment.


7. This cable was coordinated with Embassy Berlin and cleared with
Treasury Acting DAS Meyer.
POWELL