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OO RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV
DE RUEHFT #1684 1500928
ZNR UUUUU ZZH
O 290928Z MAY 08
FM AMCONSUL FRANKFURT
TO RUEHC/SECSTATE WASHDC IMMEDIATE 6726
INFO RUEATRS/DEPT OF TREASURY WASHDC IMMEDIATE
RUCNMEM/EU MEMBER STATES  IMMEDIATE
RUCNFRG/FRG COLLECTIVE IMMEDIATE

UNCLAS FRANKFURT 001684 
 
SIPDIS 
 
DEPARTMENT FOR EUR/AGS 
TREASURY FOR LUKAS KOHLER/OFFICE FOR EUROPE AND EURASIA 
 
E.O. 12958: N/A 
TAGS: EFIN ECON EU GM
SUBJECT: ECB Monetary Operations Have Unintended Effects on 
Interbank Lending Market 
 
ENTIRE TEXT IS SENSITIVE BUT UNCLASSIFIED.  NOT FOR INTERNET 
DISTRIBUTION 
 
¶1.  Summary.  Despite some signs of a return to financial stability 
in the euro zone, the dysfunctional state of interbank lending 
remains a cause of concern at the European Central Bank (ECB). 
Private banks continue to rely on the ECB for liquidity, reflecting 
ongoing confidence issues in the banking sector.  Seeing no way to 
quickly bring the interbank market back to normal, the ECB will 
continue to inject liquidity into the market. The ECB recognizes the 
possible unintended effect of replacing interbank lending and 
thereby delaying a money market recovery.  End Summary. 
 
¶2.  In a conversation with Treasury Acting Deputy Assistant 
Secretary Eric Meyer and Congen Econ Off, an official in the 
European Central Bank Division for Monetary Policy Stance said that 
while he saw no impending credit crunch in Europe and no signs of 
contagion spreading to the wider economy, he remained concerned 
about ongoing dysfunction in interbank lending.  Prior to August 
2007, European interbank lending rates, as measured by the Euro 
Interbank Offered Rate (Euribor), hovered five to ten basis points 
above the ECB rate, reflecting trust between counterparts in the 
sector.  As interbank lending froze up at the start of the turmoil, 
the Euribor shot up.  To date, it stands approximately eighty basis 
points above that of the ECB.  While low-risk overnight lending 
between banks has returned to normal, the official said that the 
market for three-month lending was not working as banks continued to 
rely on collateralized ECB monetary operations as a source for 
longer-term liquidity. 
 
¶3.  The ECB official pointed out that the Euribor was becoming an 
increasingly meaningless measure of interbank lending rates because 
the overall number of transactions on which it is based has 
drastically decreased.  He said that over three hundred banks 
currently submitted winning bids for ECB liquidity, but the number 
"could be in the thousands" if the central bank increased the volume 
of liquidity.  He described the bidders as "big, well-established 
banks paying over price," whose bids were geared to the Euribor 
rate.  The continued demand for ECB liquidity suggests that the 
actual cost of non-collateralized interbank lending remains higher 
than what the Euribor indicates and what banks bid for ECB 
liquidity. 
 
¶4.  The official suggested that one contributing factor may be that 
ECB monetary operations are confidential, a valuable commodity in an 
atmosphere where banks do not trust each other.  Yves Mersch, a 
governing council member at the ECB, said publicly two weeks ago 
that private banks were deliberately handing over low-rated assets 
as collateral for ECB liquidity since they are unable to sell these 
assets on the open market.  The risk to the ECB of holding such 
collateral remains low as both the asset and the bank would have to 
fail for the central bank to lose money, while the ECB still earns 
interest on its operations.  However, Mersch worried about a moral 
hazard:  "We are not in the business of taking over the market. 
That means there must be an exit strategy."  The ECB official 
admitted that banks have repackaged bad assets and given them to the 
ECB, thereby converting non-liquid assets into liquid ones. 
 
¶5.  For the ECB official, the greater worry was that the ECB risked 
replacing the money market, thus delaying or preventing a return to 
normality.  However, he saw no way out of the situation saying that 
the ECB "did not have the tools to fix the situation."  In fact, 
since March 2008, the ECB has offered liquidity on even more 
attractive terms, including six-month as well as three-month loans. 
The official argued that central bank liquidity was only a stop-gap 
measure and that the end of the crisis of confidence would only come 
when private banks regained trust in one another and resumed normal 
levels of interbank lending.  A senior economist at Deutsche Bank 
told Acting DAS Meyer and Congen Econ Off that he expected permanent 
changes in the interbank lending market, with future rates at twenty 
basis points above the ECB. 
 
¶6.  Comment.  The global financial turmoil that began in August 2007 
has had, on the surface, only a limited impact on the euro zone, as 
the ECB has staved off an overall credit crunch and prevented 
contamination to the economy as a whole.  However, the continuing 
dysfunction of the money markets remains a concern for the ECB, 
especially given the possibility that its own monetary operations 
could play a role in forestalling recovery.  Central bankers have 
acted boldly to stave off a wider crisis, but the unintended 
consequences of these actions are only beginning to be apparent. 
End Comment. 
 
¶7.  This cable was coordinated with Embassy Berlin and cleared with 
Treasury Acting DAS Meyer. 
POWELL