Wells Fargo Advantage Funds writes in its latest "Overview, Strategy, and Outlook" about concerns over Europe. The monthly "Money market overview" by Dave Sylvester says, "The growing credit crisis in Europe dominated the news in November. After going to the aid of Greece this past summer, European authorities found themselves fighting increasing concerns about sovereign and banking credits in other parts of the continent. This crisis in confidence culminated over the U.S. Thanksgiving holiday weekend, when the European Union (E.U.) effected a plan to rescue Ireland from the turmoil that has surrounded its banking industry.... As events have unfolded, investors have perceived increased credit risk in all European sovereign credits but especially those in the peripheral countries."
Sylvester writes, "The question is: Should the concerns that were appropriate in the case of Greece and Ireland be extrapolated to other European countries? And, perhaps more important from a money fund portfolio perspective, why has concern about sovereign credit quality become an issue for bank credits? For some time now, a country's ability to support its banks, or 'sovereign lift,' has been part of market participants' evaluation of the credit quality of banks.... While widely decried, 'too big to fail' has actually been viewed as a positive credit attribute. In the current environment, however, some bank credits have actually become fundamentally stronger than the countries that are presumed to be in a position to support them.... While we do not at all dismiss the psychological impact of the continued pounding on this theme by major news outlets, we feel that there are fundamental factors suggesting that not all Europeans should be painted with the same broad brush."
The piece continues, "While funding pressures on European banks have increased, funding through the ECB remains a viable alternative. In 2008, swap lines between the U.S. Federal Reserve (the Fed) and the ECB allowed the banks to access U.S. dollar funding through this facility and were a major factor in stabilizing the markets in that period. These swap lines, which were reinstated in May 2010 during what can now be seen as the initial phase of this episode, will remain in place until at least January 2011. In addition to providing deep pockets for the European banks to tap, the penalty rate should (or may) serve as a cap on rates, ensuring that the banks' funding costs do not get out of hand."
It says, "The ECB also seems to have room to furnish additional liquidity to its banks on its own. Based on the amount of collateral that is available at European banks, it is reasonable to conclude that the ECB could fund its banks for several years, assuming that they were willing to expand their balance sheets to the degree that the Fed and the Bank of England have done. Whether or not the ECB is comfortable with providing this level of liquidity, given its historical focus on limiting potential sources of inflation, is another question. In discussing the government bond purchase program, Mr. Trichet emphasized that, unlike the Fed, the ECB is not engaged in a quantitative easing program and has withdrawn liquidity from the system in amounts equal to its bond purchases in order to limit the risks of inflation. Still, should the situation escalate, the ECB has the capacity to address the problem."
Wells explains, "During the summer, the initial phase of this crisis in confidence was alleviated through the application of 'stress tests' to banks, similar to those performed in the U.S. Although they were widely criticized at the time for their lack of rigor, the tests succeeded in convincing the markets that the European banks were fundamentally sound. European authorities envisioned conducting follow-up tests by a newly created entity, the European Banking Authority (EBA). However, that agency is not scheduled to begin operations until early 2011, and there are already signs of disagreement among the member states about the structure of the EBA and the nature of the tests. Hopes are that the EBA will get up and running sooner rather than later and that the stress tests might be completed before the now anticipated target of mid-2011."
Finally, Sylvester writes, Early indications are that the stress tests might focus on liquidity, a new favorite of the banking regulators. We discussed the liquidity coverage ratio and the net stable funding ratio that were part of the Basel III accords in some detail in our September commentary. In short, both are designed to induce banks to favor longer-term retail deposits over shorter-term wholesale funding. This is all well and good, but whether or not market participants will be inclined to extend longer-term credit in this environment depends on confidence being quickly restored. While we remain confident in the fundamental credit quality of the selected European banks that we have approved for purchase, we are cautious in terms of our use and continue to monitor developments closely.
