But the inflationary effect of this ultimately new load of debts has become an issue in Europe where banks are reeling to secure funds and are increasingly hesitant to lend to each other in the light of the latest European banking failure. On Tuesday, Belgium banking giant Dexia was saved with capital injection of €6.2 billion by France and Belgium. In Iceland, the government took over the helm at Glitnir bank, the third biggest bank of the remote island nation.
According to MarketWatch the overnight LIBOR (London Interbank Offfered Rate) at which banks borrow FRNs from each other, shot from 2.6875% to 6.875%, recording the biggest one-day change ever.
The Euribor, benchmark rate for interbank lending in Euros, reached a high of 5.22%, hovering almost one point above the ECB's leading overnight rate of 4.25%. And this comes on the heels of Monday's announcement by the ECB that said the central bank would stand ready to provide unspecified amounts of liquidity in ongoing special refinancing operations.
Analysts are not that optimistic. The Telegraph has a good roundup of Europe's latest banking woes, written by Ambrose Evans-Pritchard and its effects on credit markets.
Europe's credit markets have come close to seizing up as three-month Euribor jumped to a record 5.22pc and OIS spreads rocketed to 113 basis points.On Tuesday, two voices could be heard from the ECB's governing council. President Jean-Claude Trichet headlined his speech for a ceremony where he was awarded the "European Banker of the Year 2007" with a simple "Some lessons from the financial market correction"
"The interbank market has collapsed," said Hans Redeker, currency chief at BNP Paribas.
"We're now seeing a domino effect as the credit multiplier goes into reverse and forces banks to cut back lending to clients," he said.
Mr Redeker said the latest alarming twist is a move by banks to deposit €28bn in funds at the European Central Bank in a panic flight to safety. This has jammed the mechanism used by the authorities to shore up the financial system in a crisis.
"The ECB is no longer able to inject liquidity because the money is just coming back to them again. This is extremely serious. If monetary policy is no longer working, there is a risk that the whole system will blow up in days," he said.
First, the root of the problems for many financial institutions affected by the market distress was their inability to adequately assess the risks associated with the exposures they held, either directly in their books, or indirectly, via off-balance sheet entities. Imperfections in risk management systems as well as in risk governance proved to be substantial contributing factors to the accumulation of exposures whose long-term risk characteristics were not properly identified in advance. With the reversion of the housing and credit cycles, and the drying up of liquidity in certain market segments, a substantial part of these exposures turned out to be overpriced, pressing financial institutions to book substantial losses. Clearly, risk management failed to provide accurate signals for institutions to build up sufficient cushions that could absorb losses, when materialized.
Second, financial institutions came short of addressing the flawed incentives created by the originate-and-distribute model. Recent events have revealed again that sound underwriting standards are key for preserving stability both at firm and systemic levels. Over the period preceding the market correction we had seen credit standards declining substantially across the board, triggering an unprecedented surge in delinquencies on sub-prime mortgages recently. As unfavourable events continue to unfold, with house prices declining and economic growth decelerating in many countries worldwide, financial institutions have to face further write-downs on their low quality exposures.
Third, the lack of transparency throughout the securitisation process that engineered the underlying mortgages into complex structured products made it difficult for market participants to identify where the risks were accumulating in the financial system and to assess the possible losses from these exposures. This opaqueness of the securitisation process, accompanied by investors’ over-reliance on, and poor understanding of, external ratings, seriously undermined investor confidence and continue to put strain on the financial markets.
Fourth, with liquidity strains characterising certain market segments, it became impossible for firms to properly value a range of financial assets and off-balance sheet exposures. Admittedly, the existing standards on valuation and accounting proved to be inadequate for illiquid markets.
The sources of the current turbulence on financial markets are manifold. So are the consequences. What we can see now is that financial institutions are becoming increasingly under pressure to clean their portfolios and to strengthen their capital base, reinforcing the rapid de-leveraging process already underway. These tendencies, accompanied by increasing risk-aversion and the tightening of credit standards, may have substantial impacts on the real-economy that policy makers should be aware of. In this context, regulators and supervisors have to face the challenge of finding the narrow path between giving prompt and adequate responses to current developments in the short run, and mitigating the mechanisms that may fuel the downward spiral of financial and economic contraction in the longer term.
Austrian governor Ewald Nowotny was quoted on CNBC, saying that the situation in Europe's banking system is far more stable than in the USA.
In the light of daily failures of European banks I tend to doubt that this wave of insolvency will be over anytime soon. Nowotny had said last Friday that the ECB's economic projections released earlier this month look already too optimistic.
Central banks remain the one-trick ponies they have been since the beginning of the credit crisis in August 2007. Any sign of stress in the system was drowned in more liquidity but the problems have only grown.
Eurozone Inflation Declines Again
Another alleviation in Eurozone inflation may keep the ECB on a stable path until December. Eurostat reported on Tuesday that Eurozone inflation has declined to 3.6% in September. It was 3.8% a month earlier.