Tuesday, May 24, 2011

Watching for Signs of European Banking Risk

The PIIGS (Portugal, Italy, Ireland, Greece, and Spain) simply can’t get out of the news lately, and the problems on the periphery of the Euro-Zone continue to create uncertainty and legitimate risk for financial markets. Debt downgrades by ratings agencies as well as the threat of restructuring, reprofiling, or just plain old default continues to hover over markets. The amount of world GDP being generated by each country is not very large, but the fat tail risk lies within the European banks that own the debt, and the possibility of cracks developing in the financial system should defaults begin to occur.

Given the problems in Europe, we are watching certain credit spreads that we believe will act as canaries in the coal mine if banking stress begins to build there. The Euribor/OIS (Overnight Index Swap) spread is one metric we are monitoring. The spread essentially compares the estimate of the effective Federal Funds rate over a given period of time (in this case three months) to the short-term rates that European banks charge each other. If the spread is widening (rising), it is one sign that there may be interbank lending stress in the system. When the spread is falling or stable, less stress is evident.

Lately the three month spread has risen off of a very low base, but hasn’t climbed back to retest the peak level from last summer, and is nowhere near the level reached during the credit crisis of 2008. The message from this indicator is that banking stress is currently contained, but it is something we’ll be keeping a close eye on given the deteriorating situation in Europe.