The new abnormal
Interbank rates: Higher interbank lending rates in Europe should be a good thing. As lenders reduce their dependence on the European Central Bank, rising rates are a sign that things are getting back to normal. However, rates rose sharply in January, and then fell back in early February. The volatility underscores the challenges of extracting Europe's financial system from its post-crisis mode.
For the past few years, the ECB has been providing banks with lots of spare liquidity. Banks have tended to draw down more than they need - a phenomenon called excess liquidity. But as the central bank gradually turns off the tap, banks will have to borrow more in the market.
This is what appeared to happen in January. During the month, banks reduced excess liquidity from ¤106 billion to just ¤7.5 billion – the lowest level for 18 months. That helped push up the overnight interbank rate – called Eonia – from 0.4 per cent to 1.3 per cent.
Then, the market went into reverse. Banks rushed to increase their ECB borrowings, pushing up excess liquidity to ¤40 billion. The overnight rate has since fallen to 0.5 per cent.
The reasons for this behaviour are not clear. One explanation is that banks are weaning themselves off the ECB. In that case, the recent gyrations are part of the return to normality.
Another possibility is that some banks are being encouraged - perhaps by their national central banks - to cut ECB borrowings. After all, the ECB has made it clear that it wants to crack down on "addicted" lenders in Europe's peripheral economies that rely excessively on its funding.
A third theory is that one or more banks ran out of acceptable collateral. The ECB has recently introduced higher haircuts for lower-rated collateral, making it harder for weak banks to borrow large amounts.
Whatever the real reason, there are two conclusions. First, it's too early to say the Europe's banking system is back to normal. Second, any return to normality will be volatile as banks come off the ECB drip. The hope is that a new round of stress tests and capital injections bolster Europe's banking system and ease funding concerns. Until then, abnormal may be the new normal.