European Banks Still Nervous About the Markets

Excerpts below from an article in the WSJ indicates that the European banks are still nervous about lending to one another. Although the ECB and the BOJ started pulling some of their money out on Tuesday the European banks interbank lending rates remain relatively high. Note that the ECB and BOJ have not pulled that much money out and the Fed and the Bank of Canada injected cash on Tuesday. As stated in earlier posts this problem has not been resolved.

As Europe's money markets calm down and central banks cut off the extra cash they have been providing to avoid a global credit meltdown, several indicators show commercial banks remain unusually hungry for cash and nervous to lend to each other over longer periods.

After four days of flooding money markets with funds, the European Central Bank and Bank of Japan effectively drained a little liquidity from the markets yesterday, in a sign of confidence that the global financial system is returning to normal.

The Federal Reserve Bank of New York canceled a $7 billion overnight injection of funds it had set for 9:30 a.m. yesterday, blaming technical problems, and then implemented it at 10:30 a.m. The snafu rattled the markets briefly.

The Fed had alerted the market to its intentions early in the day. To suggest the maneuver was more ordinary than a response to the continuing strains in credit markets, it said the intervention would be needed "to accommodate heightened reserve needs typical" on a day when the Treasury is raising money in the bond market.

The return to business-as-usual at the ECB was encouraged by falling short-term lending rates on overnight markets, where the rate at which banks lend to each other hovered yesterday around 4%, the target set by the ECB, which governs monetary policy for the 13 nations that share the euro currency. That rate was far below the highs near 4.7% last Thursday that prompted the ECB to step in.

Central banks manage economic growth and prices by setting a target for the rate on overnight loans between big banks. Then, they use open-market operations to increase or decrease the supply of funds in order to keep the market rate near the target. When the rate moves far above the bank's target rate, it signals that liquidity in the market is tight and banks are unwilling to lend to each other.

But a potential reason the ECB didn't intervene yesterday, analysts say, is that it had flooded euro-zone markets with its weekly infusion Tuesday. During its regular weekly money-market operation, the ECB injected €73.5 billion ($99.5 billion) more than it had budgeted. As opposed to the unscheduled cash injections, which were short-term, banks can hang onto these funds for a week.

"This huge weekly injection has relieved the pressure for the ECB to be undertaking massive daily injections," said Julian Callow, chief euro-zone economist with Barclays Capital in London, in a research note. "It means also that there is now a large cash surplus in euro-area money markets, which has pushed the overnight rate down."

At the same time, longer-term money-market interest rates are rising -- an indicator banks are becoming more nervous about lending to each other for longer periods of time.

The three-month euro money-market rate rose to 4.5% yesterday from 4.4% last Thursday, according to the European Banking Federation. Analysts say the rise reflects banks' fears that some victims of the U.S. subprime fallout have yet to emerge.

"Banks are still afraid of lending to each other for longer periods," said Antonio Villarroya, an interest-rate strategist at Merrill Lynch in London. "They fear the counterparty risk, and they fear that they might need the money themselves."