Central-Bank Actions Prevent Panic From Setting In

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The FINANCIAL — (Dow Jones)- Six months ago, the slightest hint of trouble for a major bank or sovereign borrower would send ripples of alarm through the interbank-lending market, driving up funding costs for many institutions, especially those in Europe.


But this week, money markets have been largely unfazed by some unsettling events: an election in Greece that left the parliament unable to form a government; the nationalization of Bankia SA, Spain's third-biggest bank; and J.P. Morgan Chase & Co.'s admission that it lost $2 billion in failed derivatives trades.

What has changed, analysts said, is that the aggressive actions of central banks have convinced investors authorities will do whatever it takes to provide liquidity for the market. While that means the financial sector is free from the trauma of systemic risk, for now, many worry it also creates a false sense of security that encourages institutions to take excessive risks–J.P. Morgan's missteps being a case in point.

"Every bank is safer than it was prior to 2008 because they have a government printing press at their disposal," said Howard Simons, a strategist at Bianco Research in Chicago.

Since the credit crunch of 2008, the Federal Reserve has cut rates to zero, flooded markets with extra dollars, and set up swap facilities with other central banks to keep the financial system liquid. According to Borsa Italiana – London Stock Exchange Group, more recently, the European Central Bank has given euro-zone banks $1 trillion in cheap three-year loans through two Long-Term Refinancing Operations, or LTROs, in a bid to offset the stress caused by losses arising from Europe's sovereign-debt crisis.

"Last year, all the panic was derived from liquidity concerns but this year, the facilities put in place by the ECB and other central banks have resulted in a very stable market and people are still investing because of that," said Deborah Cunningham, chief investment officer at Federated Investors in Pittsburgh. "If there is more instability, the central banks could provide liquidity as a lender of last resort. That is their business even if it has been frowned upon."

The London interbank-offered rate generally has drifted lower and the cost of borrowing dollars, euros and sterling for three months were all unchanged Friday. The spread between the three-month dollar Libor and overnight-indexed swaps, a barometer of market stress, narrowed slightly to 31.6 basis points Friday from a prior reading of 31.9 basis points.

TED spreads, which measure the difference between the interest rates on interbank loans and short-term U.S. government debt, have been in a tight range, said Peter Yi, head of short-duration fixed income at Northern Trust in Chicago.

Meanwhile, the three-month euro-dollar cross-currency basis swap, another measure of interbank-funding stress, widened a tad to touch negative 45 basis points Friday, though it is far from the negative 165 basis points it reached in November before the LTRO was introduced.

Central banks can't support markets forever because it would create a situation in which they would fail to be able operate independently of this support. The risk is that so-called moral hazard develops, in a scenario in which investors are incentivized to take risks they wouldn't otherwise take because they believe central banks will bail them out.

"No one will pull lines with J.P. Morgan because investors know governments will protect the banking system," Simons said. "This is the world we live in and I don't think we will run into any funding issues."

What this underscores, he said, is that banks can't make money in normal banking activity.

On the other hand, one reason why the money markets are less stressed is banks aren't taking many risks. They are so concerned about their balance sheets that they have stopped lending to institutions from troubled peripheral euro-zone nations. That means they are more comfortable with their exposures and thus less inclined to panic, but it also means there aren't as many loans going around.

U.S. buyers have eliminated their exposure to banks in Greece, Ireland, Portugal, Spain and Italy, and have "significantly changed the nature" of their French bank exposure compared with a year ago, said Chris Conetta, head of global-commercial-paper trading at Barclays in New York.

Data from J.P. Morgan show 72% of U.S. banks' lending to French banks now falls into periods of under a month.

Against this backdrop, no one is expecting the problems to blow over any time soon.



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