Judging by the action in the various indicators of bank funding stress, the ECB measures announced on December 8th do not appear to have had any discernible material effect on market expectations surrounding bank liquidity. The market action of bank shares such as Deutsche Bank (DB) in Europe and investment banks in the U.S. such as Morgan Stanley (MS) that are highly sensitive to this issue are also signaling that there is a major bank funding problem brewing.
The question is, why?
It is clear that many depositors and money market participants are essentially engaged in a “run” on European banks. However, with the ECB committed to providing “unlimited” funding for up to three years, it is not immediately apparent why there should be any funding stress at all.
One theory is that there is a “collateral shortage.” The ECB only provides liquidity in exchange for certain types of collateral. Furthermore, they only provide a certain percentage of the value of certain assets. The amount of the “high quality” collateral that certain banks have may not be sufficient to cover their loss of funding sources (that previously did not have collateral requirements). Under that theory, many banks are essentially being shut out of the ECB and thrown to the “wolves” in the private market where they must pay high rates of interest.
Based on my knowledge of this issue and the data that I have seen, I am not sure that a “collateral deficit” can explain the funding stress – unless the deposit withdrawals and money market fund withdrawals are of a MUCH greater magnitude than anything that can be discerned from publicly available information.
Another possibility is that the market is exhibiting a delayed response to these measures and that the restoration of fluidity in the system will be gradual. Again, this is not a particularly satisfying theory. Surely there should have been some positive market response if the measures are expected to make a difference.
The tentative conclusion I derive from the lack of market response to the newly announced ECB measures is that risk of a major banking crisis in Europe is extremely high. If some banks are currently finding it difficult to acquire funding, and they are being shut out by the ECB due to relatively stringent collateral or other requirements, then a continued run on European banks by depositors and money market fund managers could bring one or several of these banks to the breaking point at any moment.
In this regard, unless the upcoming EU summit changes the psychological dynamic significantly and restores confidence in European financial institutions, a “Lehman event” could occur within days of December 9.
Market participants have been focused on sovereign bond yields. But the real stress point, and potential crisis catalyst, may be in the funding market for banks.
If there is not a discernible improvement in indicators of bank funding stress in the next few days after Dec 9th, I think that a “Lehman event” could be very near - perhaps prior to December 31, 2011.
Due to the incredibly high risks and stakes involved, it is my view that all but the shortest-term traders should refrain from attempting to play the equity market on the long side through individual stocks or equity market proxies such as SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF Trust (DIA) or Powershares Nasdaq-100 Index Trust (QQQ). I believe that investors with longer time horizons should raise cash and avoid purchasing and/or holding equities - even those that appear attractive such as Apple (AAPL), Microsoft (MSFT) and Pepsi (PEP).