More on European Interbank Lending

I've done a bit more digging into what's going on in the European bank funding market. Apparently, the issue is not so much that the banks bidding for ECB funds can't borrow at Euribor, but that they cannot do so in size. This is because banks still have tight counterparty exposure limits, and also because their balance sheets remain constrained.

The counterparty exposure issue is that Bank A's risk managers have set a limit on the maximum it can lend to Bank B. These limits are currently small in historical terms. So even if Bank B wants to borrow more, and Bank A's traders want to lend, they are constrained from doing so by Bank A's risk policies. As a result, Bank A is forced to put excess funds on deposit with the ECB at 0.25%, rather than lend it to Bank B at 0.35%.

The balance sheet issue is that making loans in the interbank market requires banks to hold capital against those loans, and that capital is still quite constrained. So while banks are awash in liquidity, they are unable to put that liquidity to work because they are unwilling to use the capital necessary to support the lending.

The result is that banks that are short of funds have tapped out their private credit capacities and must borrow the balance at the ECB at 1%. Meanwhile, banks with excess funds have hit their risk limits and must lend the balance to the ECB at 0.25%.