Banks don't want to pay for funding when they can get it for free

As US banks continue to grow their deposit base, they are reducing reliance on commercial paper (CP). Why pay for funding when depositors are willing to provide capital for free and in increasingly larger amounts? On the other hand foreign-owned banks, a number of whom don't have a large retail presence in the US, have recently increased their issuance of CP. The chart below shows the divergence in CP outstanding between the two groups.

Source: FRB

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The squeeze on dollar funding in the Eurozone continues

The latest data on US money market funds is continuing to show reduction in holdings of Eurozone banks' commercial paper (CP). Again, money funds do not sell their CP, they just let it mature without rolling into new paper from the same banks.  Instead money market funds are buying Australian, Canadian, Japanese, and some UK bank paper (in addition to their holdings of US CP).

Non US holdings by US money market funds (Source: Fitch)

These Eurozone banks in turn are replacing their dollar funding with dollar loans from the ECB via the Fed's liquidity swap.

Fed Liquidity Swap

The impact of this transition will be a substantial reduction of dollar assets and even whole dollar businesses at European institutions. US corporations, real estate firms, US energy projects (where some European banks used to be active), etc. should not expect to see substantial new lending from  Eurozone banks going forward.  Dollar lending business will now be dominated by US banks who have easy access to dollar funding.   

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Severe dollar funding constraints will push EU banks out of US markets

The tightness in dollar funding continues to be a major problem for a number of EU banks. Much of it is driven by US money market funds not rolling their commercial paper (CP) holdings issued by eurozone banks. As CP matures, European banks have to find alternate sources, which is proving to be difficult.

Yahoo Finance: "It is utter madness ... When we see big names paying 300 basis points over overnight rates for dollars you know something is wrong," said the head of money markets at a bank in London, who asked not to be named.

The non-US financial institutions' commercial paper outstanding continues to dwindle:

This demand for term dollar funding keeps putting upward pressure on interbank lending rates as banks want to charge increasingly more to part with dollars for longer than overnight:

3M USD LIBOR

The ECB has responded by tapping the Fed Liquidity Swap Facility this week in the amount not seen since 2009 in order to provide dollars to numerous eurozone banks.

Many European banks will be forced to change their business models.  This inability to raise dollars will severely constrain their activities in the US, making it increasingly difficult for them to lend to US corporations or buy illiquid US assets.  Even if the situation in the eurozone improves, these banks will be loathe to add dollar assets to their balance sheets because of potential funding risks in the future.

In many instances they will also be constrained from lending in Asia and the Middle East, where dollars are often preferred to euros because of trade with the US.  Without access to dollar funding, European banks will shift their focus to Europe, creating new opportunities for US (and in some instances UK) and Asian banks. Banks like JPMorgan and HSBC will be clear winners and increase market share because of their access to dollars.

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In Europe increased reliance on the ECB and the currency basis swap market

As a follow-up to a recent very timely post by PonzyFinance on basis swaps spread, we discuss how European banks are employing this tool. A basis swap is a quick way of converting a "floating rate" asset or liability from one currency into another.

Let's say I run a dollar denominated fund that wants to purchase a sterling loan. The sterling loan pays sterling LIBOR plus a spread. I can enter into a dollar/sterling basis swap where I receive sterling (that I use to purchase the loan), pay out dollars, and agree to return the same amount of sterling in return for dollars in the future. The exchange rate for the "spot" transaction and the reverse forward transaction are the same and would be locked on the day of closing. Until maturity I would be paying sterling LIBOR on my swap and receiving dollar LIBOR - plus/minus the basis spread. So I start with something that had a sterling notional and pays sterling LIBOR plus spread (the loan that I purchased) and convert it to something that has "synthetically" a dollar notional and pays dollar LIBOR - which is more appropriate for my dollar fund and has no F/X risk.

The chart below shows how one would could borrow euros and convert the loan into dollars via a basis swap.  Note that the basis spread is driven by the supply and demand in the market.

This is the basis spread that market participants use to ascertain how "healthy" the financial system is. European banks have access to euro funding, but are quite limited in their ability to borrow dollars. This creates significant demand for the swap structure above. That demand translates into higher basis spread (often called the "Euro basis"):

3-month EUR/USD Basis Spread (Bloomberg) 

 As PonzyFinance pointed out, the 150bp level is approaching.  So how is it that European banks get access to so much euro liquidity?  Unfortunately the answer is disturbing - many are tapping the ECB.  In particular the French banks are starting to borrow significant amounts of euros from the ECB, some of which they convert into dollars to fund the dollar component of their balance sheet (driving up the basis spread).  The chart below from Barclays Capital shows the recent increases in the funding provided by the ECB to banks from Italy, Spain, and France.

Source: Barclays Capital (click to enlarge)

As US money market funds turn away from Europe, dollar funding becomes dependent on the combination of the ECB and the basis swap market.

Here is an old GS write-up that goes through some detail on basis swaps.

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US Money Market Funds Shift Away from Europe

There is further evidence that US money market funds continue to reduce their exposure to Europe. Contrary to popular belief the funds are generally not selling paper.  Typically they hold commercial paper (short-term loans) to maturity and they are simply not rolling the maturing debt. From the NY Times:

American institutions are pulling back on loans to even the sturdiest banks in Europe. When a $300 million certificate of deposit held by Vanguard’s $114 billion Prime Money Market Fund from Rabobank in the Netherlands came due on Nov. 9, Vanguard decided to let the loan expire and move the money out of Europe. Rabobank enjoys a AAA-credit rating and is considered one of the strongest banks in the world.

“There’s a real sensitivity to being in Europe,” said David Glocke, head of money market funds at Vanguard. “When the noise gets loud it’s better to watch from the sidelines rather than stay in the game. Even highly rated banks, such as Rabobank, I’m letting mature.”

Rabobank's dollar funding constitutes about 14% of it's overall funding needs (below). However this does demonstrate that even the strongest banks in Europe are having to change their funding strategy.

So where are these firms going to obtain dollar funding? The stronger banks will obtain it in the interbank market - borrowing from other banks (JPM or HSBC for example). The weaker ones will have to rely on the Fed via the ECB. As discussed earlier the Fed's Liquidity Swap is expected to grow to accommodate this shift.

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