European financial institutions, particularly banks, have been among the biggest buyers of government debts. However this time round, they appear to have been weakened by the euro-zone’s debt crisis.
As these banks are required to increase their capital ratio requirement, credit is rapidly becoming tighter and more expensive. This could inevitably lead to a severe credit crunch, unlike the credit crunch experienced during the crisis of 2008, as banks will no longer be able to fund future demand for loans, especially with the threat of a looming recession in the euro-zone that is likely to deepen and prolong, more severe and more likely to be globally contagion.
Higher Cost and Difficulties of Funding
The nervousness that is surrounding many European banks is deeply rooted in their sovereign debt holdings. The European Banking Authority had identified a total of $143 billion gap at 70 banks that it had stress-tested for their exposures to euro-zone sovereign debts. However, instead of raising fresh capital in the equity markets to bridge the gap, many of these banks opted to shrink their balance sheets and comply with the capital ratio in that manner.
As credit becomes more expensive and funding more difficult to raise, certain areas of banking activities are beginning to show signs of aggressive shrinkage. This is especially so in businesses that require a lot of capital but with relatively low profit margins. Trade financing, especially among the small and medium enterprises, which demand high working capital and can be highly risky in times of a recession, is another area which banks are also beginning to avoid for fear that the threats of a looming recession could badly disrupt global business flows.
As fears of integrity of the euro-zone deepened, European banks are finding it extremely expensive and difficult to raise funds in the bond markets. Even as banks increased their interest rates on deposits to as high as 4%, deposits from customers are also getting scarce for fear of bank runs. At the same time, banks that are hoarding cash are also holding on to it, thus, helping to dry up the inter-bank money market, which is one of the keys mechanism for bank funding.
Creating Liquidity
To buy time and to create liquidity, the central banks of the United States, Canada, Britain, European Central Bank and Switzerland, on 30 November, acted in coordination by providing liquidity under the liquidity-swap program. In the coordinated move, the United States’ Federal Reserve slashed the dollar-swap rate it charges on dollar liquidity from 100 basis points to 50 basis points.
Under the liquidity-swap program, the United States’ Federal Reserve lends dollars to the ECB and other central banks in exchange for collateral in other currencies, including euros. The central banks lend the dollars to commercial banks in their jurisdictions through an auction process.
The swap arrangements were revived in May 2010 when the debt crisis in Europe worsened. The United States’ Federal Reserve had three months earlier closed all opened swap lines during the financial crisis that was triggered by the subprime-mortgage meltdown in 2007.
While the Federal Reserve-led global effort to ease borrowing costs for financial firms shows both the central bank’s ability to influence markets as well as the limits of its ability to alleviate Euro-zone from the debt crisis, it does not, however, allay the fear of a global contagion that is in the mind of most bankers.
Eastern Europe is extremely reliant on Western European financial institutions to provide the required liquidity. Latin America is also at risk as the woes of Spain’s banks deepen. The ability of these Spanish banks to fuel growth at their Latin branches become questionable.
Having experienced the credit crisis of 2008 which brought along with it the recession, Asian banks in Hong Kong and Singapore appeared to be prepared and ready for a repeat of the credit crisis. However, the same cannot be said for China as it is facing her own debt problems which has not only resulted from the stimulus package of 4 trillion yuan during the recession of 2008, but also from cheap and easy money during the same period.
Andrew Michael Teo 