Stress tests no quick fix for interbank lending

European stress test results could reduce funding costs for some banks but the need to rebuild credit lines could mean lending does not pick up significantly for some time.

Analysts said the tests, if judged credible, would boost confidence between banks but a crucial next step would be for policymakers to act quickly to shore up those institutions in need of support.

The tests on 91 institutions are aimed at convincing markets that most of the region's banking sector can withstand another economic downturn and losses on government debt, and that authorities can deal with those that need recapitalizing.

Banks' inability to lend has been at the heart of the global financial crisis.

Some banks from countries such as Greece, Portugal and Spain, at the epicenter of the euro zone sovereign debt crisis, have been squeezed out of the interbank market on fears of counterparty risk, while funding costs have risen for others.

Financial markets are guardedly optimistic about the test results, with the major banks seen solid and just a few failures expected in Portugal and Spain, though lack of details has led investors to wonder whether the tests will be tough or transparent enough.

"I'm not sure the stress tests will be the silver bullet by any means. They are just one piece in the puzzle," said Peter Chatwell, an interest rate strategist at Credit Agricole.

"Generally the more capital banks have, the better it will reduce counterparty risk. Transparency with regards to that topic would be helpful."

Key for most investors is disclosure about banks' exposure to government debt from Greece, Spain and Portugal -- countries that have struggled to convince lenders they can deal with their high debts in the face of slow economic growth.

No panacea

Data released this week showed banks from those countries remained reliant on European Central Bank funding, with Greek banks' borrowing from the ECB up almost 5 percent at the end of June from the previous month. Borrowing by Portuguese banks reached a record 40.2 billion euros ($51.88 billion) in June.

That trend is seen unlikely to reverse any time soon after the stress tests.

"Stress tests themselves are not a panacea for the market and for interbank lending. If the numbers are fantastic tomorrow it's not going to open the lending spigots," said Kenneth Broux, a financial markets economist with Lloyds TSB.

"Building confidence is going to take time. It depends how low or how high they raise the bar of the results -- confidence is very fragile."

Forward rate show money markets are fairly sanguine about the stress tests, with FRA/OIS (forward rate agreement/overnight index swaps) spreads tighter than at the beginning of the month. The September 2010 spread stood at 34.8 basis points on Thursday compared with 37.3 basis points on July 1.

U.S. fund managers and analysts said that even if investors perceived the test results as credible, they did not expect risk-taking to bounce back for long, given that Europe's fundamental backdrop remains relatively grim, especially with fiscal austerity the norm.

Money market traders also said interbank lending was unlikely to pick up quickly, given the length of time it would take for credit managers to adjust credit lines to other institutions.

The tests could add to a tentative return in confidence in peripheral bond markets, reinforced by successful debt sales by Ireland, Greece and Spain, albeit at higher yields, in recent weeks, analysts said.

If the results reveal more failures than expected or more banks needing to rebuild their balance sheets, the European Central Bank could postpone its unwinding of extraordinary liquidity measures, which could see money market rates reversing their upward projectory.

Euro interbank rates have been on an uptrend especially after banks paid back 442 billion euros of one-year loans to the ECB on July 1, taking a big chunk of excess liquidity from the market, with three-month Libor fixed at an 11-month high of 0.81625 percent.

"The ECB extending its exit strategy by another six months or so should lead to falling money market rates," said Kornelius Purps, a strategist at UniCredit.

[Source: Reuters, Brussels, 22Jul10]

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