Europe’s banks are suffering a two-pronged funding crisis, but only one is getting a cure. The European Central Bank is addressing money market strains by flooding markets with cheap short-term funds. But it should also offer relief for troubled long-term bond markets.
The euro zone’s sovereign debt crisis has cast a shadow over the solvency of European banks. Bank credit spreads are at record highs: the Markit iTraxx index of swaps tied to senior bank debt is about 130 basis points higher than during the crisis that followed the failure of Lehman Brothers in 2008. No public senior unsecured bonds in banks have been sold in Europe since early July, according to Societe Generale. If markets don’t reopen properly, Europe’s lenders will struggle to raise the 1.7 trillion euros that Morgan Stanley thinks they will need over the next three years at affordable levels. They may sell assets and rein in lending instead, further squeezing economic growth.
Governments could step in by injecting capital or guaranteeing bank debt. However, that risks exacerbating the feedback loop between banks and troubled sovereigns. Europe’s bailout fund could be adapted to help banks, but that would require governments to go through the lengthy process of seeking parliamentary approval for the changes.
That leaves the ECB. The central bank already provides banks with unlimited liquidity up to six months, and could easily set up a longer-term facility. In 2009, it offered banks one-year money. This could be revived, or even extended to three years.
The risk is that such a scheme would prop up weak banks, so any lender using the facility would have to pass a stress test to make sure it had sufficient capital. Even then, there’s a danger that strong banks take advantage of cheap funds. However, the ECB could limit the amount a single bank can borrow, and set a penal but still affordable rate. The premium could even ratchet up over time as sovereign and bank credit-default swap spreads narrow, giving banks an incentive to repay the loans early.
Secured funding from the ECB won’t necessarily help banks issue unsecured debt. Still, a longer-term facility would boost confidence, help reassure other investors and ease the pressure on banks to deleverage. The ECB should not delay.