ECB Exit Strategy and Counterparty Risk

By end-September 2010, about €225 billion in three-, six- and 12-month longer-term refinancing operations came to maturity. Eurozone banks had the option to roll the maturing loans over into new three-month and six-day loans at a 1% fixed rate and full allotment. Banks chose only to roll over about €145 billion and repay the rest, thus significantly reducing the amount of excess reserves deposited at the ECB. Indeed, according to the latest available data, the amount of excess reserves declined to about €30 billion in October from almost €100 billion in September. As a result, the unsecured three-month interbank lending rate (EURIBOR) spiked to 96 basis points, while the effective EONIA overnight rate is also gradually trending upward, toward the main refinancing rate of 1%.

Spread Between 3-Month Repo Rate and 3-Month Government Bills


Key events: 1) Bear Stearns rescue; 2) Lehman bankruptcy Source: Bloomberg, RGE

Given the still unlimited liquidity supply at fixed rate, the ECB is justified in pointing out that the excess liquidity withdrawal is happening on a voluntary basis, thus implying a gradual normalization of the money markets. Nevertheless, two important issues warrant mentioning. The first is that, as the ECB prepares to shift toward liquidity provision at flexible rates sometime in 2011, it is likely that a subset of banks will remain dependent on ECB liquidity. As pointed out by RGE, in a risk-on/risk-off environment the risk of contagion—amplified by tight funding conditions—remains elevated. Secondly, counterparty risk among eurozone banks remains high compared with that among peer banking systems in advanced economies (see Figure 1), despite the apparent normalization of liquidity conditions. The exit strategy may yet be postponed. (See related Critical Issue on the eurozone interbank market.)

Editor’s Note: This post is excerpted from a much longer analysis available exclusively to RGE Clients:Europe Focus: Polish Capital Inflows; UK Growth; Norway’s Budget

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