THE EUROZONE

The Eurozone

The Eurozone

Introduction

During the spring of 2010, financial markets in the Eurozone started to signal a re-awakening of the global financial crisis. As the euro sovereign debt crisis gained momentum, the euro embarked on a steep slide, and government bond and credit default swap (CDS) spreads started to rise dramatically, reaching levels not seen since the introduction of the common currency. (Wray, 2010, 33)

Further, renewed pressures in the money market pushed up London Interbank Offered Rates (Libor), as banks became reluctant to lend to each other - fuelled by the uncertainty about each other's exposures to peripheral European countries and what the effects of the fall in prices of sovereign bonds might have on their balance sheets when marked-to-market. Libor-OIS spreads (both for the dollar and euro loans) started to widen again, after a long period of narrowing following central banks' injections of vast amounts of liquidity into the banking systems in the aftermath of the Lehman Brothers collapse. Arguably even more importantly than Libors, both the FX swap and the cross-currency swap markets started to indicate serious strains in the interbank lending market for dollars. As the latter involves real cash, ie, physical exchange of notional often with dollars on one side, it is a better gauge for the relative demand of the currency than the indicative and non-binding Libor setting process. (Allwright, 2011, 58)

These strains were a symptom of European banks being unable, or having to pay a high cost, to fund their activities in the United States, which had surged since the launch of the euro. With the European Central Bank (ECB) unable to offer dollars, and the Federal Reserve unable to lend dollars directly to European banks, dollar swap lines were, as in the case of Lehman Brothers, yet again set up to protect the health of the banking system. The drivers this time were different, however, as we shall explore.

The funding gap problem

European banks have faced funding problems from different sources: in addition to short-term funding problems reflected in Libor, banks have also experienced more medium term funding problems (such as rolling over their corporate debt), reflected in higher CDS spreads (see figure 1).

Moreover, reflecting the increased internationalization of the banking system and as highlighted in this article, European banks face a specific funding gap for dollar assets as a result of them taking positions in dollar-denominated assets. (Bolle & Jacobsen, 2001, 298)

Why funding gaps exist

Funding gaps exist because as a bank seeks to diversify internationally, or expand its presence in a specific market abroad, will have to finance a particular portfolio of loans and securities, some of which are denominated in foreign currencies (e.g., a German bank's investment in US dollar-denominated structured finance products). These operations can typically be funded either through FX spot transactions, dollar-denominated borrowing (e.g., interbank) or euro-denominated borrowing swapped to dollar (Allwright, 2011, 58).

This international expansion has been particularly prominent for Eurozone banks since the introduction of the euro. The euro has provided liquidity facilities regulated by ...