LONDON: The cost of raising funds in dollars soared for euro zone banks on Thursday due to fears of a Lehman-like lending freeze hitting interbank markets if a new Greek rescue deal is not struck in time to plug a financing gap.
A standoff over how to make the private sector contribute to Greece's bailout and the risk that the government could collapse in a no confidence vote next week add to the perception of a systemic risk in money markets -- used by banks to manage day to day cashflows.
The one-year euro/dollar cross-currency basis swap, which shows the rate charged when swapping euro interest payments on an underlying asset into dollars, posted its sharpest one-day fall since early May 2010, before Greece's first bailout deal was reached.
"It is evident that market players are fearing a drying up of liquidity," said Philip Shaw, chief economist at Investec.
The swap fell to -37.5 basis points, compared to -30.5 bps on Wednesday and -24.75 on Tuesday, a level which was comfortably within this year's range. The two-day fall wipes out half of the gains the swap made this year.
A fall in the swap reflects a reluctance from US banks to lend dollars to euro zone banks at a time when demand for dollar assets is increasing as investors seek safe haven exposure.
It still traded way above the May 2010 levels of -61.5 bps and the -115 bps reached in October 2008 at the height of the crisis, but economists warn against interpreting the levels as a sign markets are less nervous than they were then.
"It is the speed at which the move takes place rather than the actual level which is more relevant ... We will reach the May 2010 levels in the next few days unless some kind of a Greek deal is reached before that," said Lena Komileva, head of G10 strategy at Brown Brothers Harriman.
Eurodollar futures also fell across the 2011-2013 strip, with expectations that the three-month dollar Libor -- the basis for the futures contract -- will be set higher over that period as money markets dry up, despite recently weak US economic data pointing to a low-rate environment.
Money market tension was at the heart of the banking turmoil in 2008 which drove governments to provide emergency assistance to a succession of European banks and the system as a whole.
The spread between the benchmark euro Libor rate and overnight index swaps -- another gauge of interbank stress used during the Lehman crisis -- was little changed at 13 bps, sharply lower than levels of over 100 bps seen in late 2008.
This is because the euro interbank markets are helped by the European Central Bank's unlimited lending facility designed to help ailing banks in Greece, Ireland and Portugal, as well as some small lenders in Spain, which are effectively shut out from borrowing from other banks.
When banks do not trust each other they resort to the ECB for funds, which in turn pushes the excess liquidity in the interbank system higher and drives short-term interest rates lower. Without abundant ECB cash, short-term rates would spike as banks struggled to find funds.
"What I think, ironically, is going to happen is that Eonia (the euro overnight lending rate) could drop sharply in the event of a Greek default as banks will rush to get ECB liquidity," Komileva said.
Underlying euro interbank lending stress, however, is significant. One trader said volumes for one-week unsecured lending were "extremely thin" due to the recent escalation of the Greek crisis.
That marks a change from last month, when traders were saying volumes thinned out only beyond one-month durations.
The worst case scenario is if Greece defaults in a disorderly manner -- meaning no agreement with private investors is reached for any kind of voluntary debt restructuring -- and the ECB follows through with its threat to reject distressed debt as collateral for its liquidity operations.
"That would lead to an implosion of the Greek banking system and contagion spreading across the periphery," Investec's Shaw said, adding that the impact of such a move would be so great that markets were not considering it.
Instead, it made more sense for the ECB to ease collateral rules and strengthen funding facilities such as dollar swap mechanisms, he said.
Copyright Reuters, 2011