Bank funding costs strained; dollar-based lending scarce

NEW YORK: Bank funding costs were strained on Thursday as dollar-based lending to European banks remained scarce and threats of ratings downgrades added to worries of increased collateral demands on borrowers.

The cost for European banks to obtain unsecured dollar funding has increased, nearing the worst levels since 2008, as investors pull back from making loans that are not secured by assets and lenders become increasingly selective on what securities they will accept to back secured loans.

Central banks have cut the costs of loans to banks, and the European Central Bank has loosened collateral requirements and extended loans offered to banks as far as three years in a bid to loosen credit conditions.

The move, however, has failed to help banks struggling for loans that do not hold enough assets to back borrowing, and they are being forced to obtain dollars through the increasingly expensive currency swap market.

"There is plenty of cash, but it really only wants good collateral," said Mary Beth Fisher, an interest rate strategist at BNP Paribas in New York. "This is genuinely a credit not a liquidity crisis."

European banks have been reducing lending and other US activities in a bid to reduce their dollar funding needs, though analysts see the still-high cost of the swap rate as an indication that many banks maintain a strong need for dollars.

Banks need to pay a premium of 1.32 percent to swap euros into dollars for three months in the currency swap market , a level that remains near the highest costs since 2008. The swap costs had traded at under 40 basis points in July.

The ECB accepts a broad range of assets to back loans, though it charges a higher haircut for riskier debt.

Derivatives clearinghouses, by contrast, require that banks post only high-quality collateral to back trades, and investors are starting to worry that new rating downgrades will add to strains by increasing the amount they need to post.

Fitch Ratings on Wednesday cut five major European banks, and Standard & Poor's last week warned it may implement broad downgrades of European nations and banks.

European banks are also facing large debt maturities next year, which analysts fear may add renewed volatility to the region as investors continue to worry about banks' sovereign exposure and as banks come under regulatory pressure to increase their capital ratios.

"It increases haircuts automatically when there is a downgrade. That creates some funding pressure by itself," said BNP's Fisher, adding that "next year looks like a recent high for the amount of refunding that's due in the fixed income markets from the financials."

In one positive sign, dollars offered by the ECB last week have flowed into the US repurchase market through its swap program with the Federal Reserve and lowered the cost of borrowing against Treasuries, said Scott Skyrm, head of repo trading at Newedge in New York.

"That filtered back into the US market, and overall dollar market and rates have been a little softer since," he said. "In a way the Fed eased a little bit, it used liquidity and cut rates by keeping the pressure off the European banks indirectly though the European Central Bank."