Heading for the next banking crisis?

Executive summary  Banks are plagued by the “Greek factor”: Fears of further write-downs on government debt weighs heavily on European banks.  Consequences for banks: No liquidity crisis – the ECB acts as back-stop liquidity mechanism – but elevated funding costs for term debt and capital: profit squeeze inevitable.  Consequences for the economy: As banks’ balance sheets have already improved considerably (more capital and deposits, less inter-banking business), a full-blown credit crunch is not on the cards but credit supply remains feeble – like demand from over-indebted private households and cash-rich companies.  Consequences for policymakers: Despite fresh calls for renewed support for banks such as guarantees or public re-capitalization, such a strategy is not very promising; a better and more efficient way to stabilize the banking system is to finally curb the sovereign debt crisis.

Two worries are engulfing European banks: Interbank lending is starting to freeze up again  Investors are shunning banks Indicators of the potential for another interbank lending freeze are many: growing use of the ECB’s overnight deposit facility, higher borrowing from the ECB by peripheral banks, less buying of European banks’ commercial paper by US money market funds and, last but not least, a rising Euribor-OIS spread. That investors are turning away from banks is reflected in falling stock prices, rising interest rates and CDS spreads, and falling debt issuance. The fear is that these funding constraints could spark another credit crunch – with a devastating impact on the rest of the economy, similar to the situation after Lehman’s collapse.

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