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