The Impact of European Sovereign Debt Crisis on Money Markets - Essay Example

The Impact of European Sovereign Debt Crisis on Money Markets Introduction: The peak of the crisis of European sovereign debt was realized on March 2012 when a greatest sovereign debt restructuring was carried out by Greece (Zettelmeyer, Trebesch, & Gulati, 2013). Apart from Greece, other European countries like Italy, Spain, Portugal, and Ireland are also some of the countries facing distress in finance (Lane, 2012). Euro zone is at risk because all the members of the European Monetary Union (EMU) were guarantees of each other when they were applying for the loan. Because of this, all the member state of Europe including those who are not facing the financial crisis is being watched by the international agencies of rating in a negative way. Furthermore some countries have ended up losing their investment status of grade. This incident has placed the international investors in alert. Even before the downgrading of the first country into a grade of non-investment, the stock market was down, and some countries even become close to lose their access to capital market. As a result of this the European politicians directed their blame to the crediting rating agency of making thee debt crisis worse. Since 2011, the agency of rating has to regularly register with the European Security and Markets Authority (ESMA) which is also mandated with the further preparation of the legal action (Moloney, 2011). This regulation shows that the rating of credits have some control on the capital market. Some of the money market issue that was affected by the crisis that is to be discussed in this paper includes the macro-financial risk, intra-euro area financial flow, and collateral availability. Intra-euro area financial flows In most of the countries in euro the deposits owned by the domestic banks were stable between 2010 and 2011. However the domestic banks in Ireland and Greece heavily fell. Ireland and Greece were not in a position to replace the deposits that were lost with other market borrowing or wholesale and the gap that existed by borrowing from their central banks (Whittaker, 2011). The relocation of the market money into the central bank balance sheet caused an inter-central bank debt that was very high within the system of the euro. Inter-commercial bank lending is a means of transferring money from area which have surplus to areas deficit areas (Friedman & Schwartz, 1970). For example if funds is withdrawn from the Greece bank and placed in the bank of Germany, this withdrawal will leave the Greece bank with deficit of money while the Germany bank will be in surplus of money. In the market condition that is normal, the bank in Germany might lend back the money to Greece bank. Furthermore, other international banks that are not within the euro also intermediate the interbank flow. Thing were always normal as market condition were good until 2007. After 2007, solvency of each other was lost by the banks and the money market moved to the central bank balance sheet. The banks in euro area with surplus money began to place this money in the Eurosystem. This system provided an opportunity for the banks which were short of money to borrow money from it. For example, the German banks with surplus money will place its money with the Eurosystem and this money will be placed inform of the Deutsche Bundesbank (Deutsche Bundesbank, 2006), the Greek bank will borrow the money from the Eurosystem in form of the bank of Greece. This process is reflected in the cross board development net interbank claim. Before 2007 the private sectors were very prepared to finance euro area payment imbalance. After the year 2007, there was rapid growth of the balances. Up to the mid of 2011, the debt of the intra-eurosystem were concentrated in Ireland, Greece and Portugal. In the same year deficit also was experienced in the Italy, Spain, and France. However by the end of the same year, Germany surplus had accumulate up to EUR 500 billion (Holslag, 2012) and Netherlands surplus accumulated to some billion (Magoulios & Stergios, 2013). Greece deficit accumulation at the end of the year 2011 was some billion (Featherstone, 2011). In Greece, the demand for banknotes was very low 2010 and 2011. This suggested lose in the Greece bank by the citizens (Whittaker, 2011). In 2012 the surplus for Germany continued to increase further. However during the same year France attained some balance while Italy and Spain debts significantly increased during the first of the same year. Those imbalances have contributed to inhibiting the flow of money into commercial banks, government liability; other companies in the countries believed to be insecure financially and hindered the flow of funds from the surplus countries to deficit countries from taking place. The experienced imbalance that the market was reluctant to service was perfectly financed by the Euro-system. Effects of the crisis on collateral availability After talking about the crises consequence for financial flow for intra-euro area, it is now important to review the sign of collateral squeeze resulting in the euro area (Blanco, 2001). Euro- area financial flow was partly appreciated the Federal Reserve’s timely action which at the same time had very weighty consequences of in the United States macro- economic consequences and the world as a whole. It is very clear that the crisis of sovereign debt of the euro area has also caused euro area collateral squeeze. In the year 2010, when collateral was lodged by the bank with equivalency euro system of almost three times their borrowing. In the same year, the collateral holding of the Euro-system was maintained by the banks at the same point which it was in 2009, even though there were low average borrowing systems (Weller, Köppen-Mertes, & Cheun, 2008). However the increased concern of the government ability to save the banks which were in distress and the rescues terms and the increased volatility of the asset price had likely caused a collateral condition that was tightening in 2011 (Cao, 2010). In the last few months of the year 2011, ECB collateral lending sharply increased in the last year of 2011and in first quarter of the year 2012 (Sinn & Wollmershäuser, 2012) and the amount of money stake with the ECB increased. Money market to the Eurosystem balance sheet meant that the interbank uncollateralised borrowing was replaced with the central bank collateral borrowing (Cassola, Hortaçsu & Kastl, 2013). Net borrowers banks could not unsecured in the interbank wholesale market but had to take a loan from their respective national central banks which needed collaterals. The borrowing of the commercial banks from the Eurosystem increased by billions in the year 2011 which will have drained the banking system collateral. Lending of funds to the banks had most probably increased because the crisis of the global banking had affected the European area and the contraction of the unsecured inter-bank lending; these ensured that most of the mediation of the inter-banking carried on by the Eurosystem. In the year 2010, the Eurosystem had decrease; this may be due to the fact that the market believed that the risk that existed in the inter-bank lending had reduced when there was hope for the financial assistance of the countries that were affected like Ireland and Greece (Darvas, Piasni-Ferry & Sapir, 2011). In the year 2011, a good amount of unsecured deposit in the US foreign bank (Maechler & McDill, 2006), the withdrawal was anticipate by the banks when they remitted from their non- US office. The funding of these remittances will have needed collateral pledging or asset sales which may have served as collaterals. The margin of the surplus collateral was caused to increase by the volatility increase of security pricing of the government (Hördahl, & King, 2008). This represented a narrowing of assets range regarded as safe and liquid. For example in relation to volatility of the market in the rise of a statement of European Council (Lugna, 2006), collateral margins on trades that are unsettled were increased by the LCH Clearnet SA. This also included repos in the securities in the government of Italy. Due to the increase, there was a sharp drop in the security prices of the Italian government (Burda, & Wyplosz, 2012). An example is the creation of a positive feedback using the algorithms designed for risk management. Macro-financial risks The first risk is that some countries will be in a place that will make them not to be in a position to pay their debt. This will put them in a position to either put bondholders in a point where they had no solution but to accept the bond variations which will automatically involve a value lose or simply default on the debt (Macmillan, R. (1995). The above two possibility which are legally different will have the same effect to the banks. During the end of the year 2010, the banks of European had exposures of EUR 90 billion to Greek sovereign debt, compared to EUR 1,006 billion core tier 1 capital. The exposures of the Greek were unevenly spread, though Greek bank had exposure gross of EUR 54 billion to Greek sovereign debt, compared to core tier 1 capital of EUR25 billion (Allen & Moessner, 2012). The risk that the default from the government will endanger the commercial bank solvency caused a reaction that was contagious. It was exceedingly obvious that there were some banks that were in danger, however what was not clear was the names and number of banks that were exposed to these banks that were in danger. Therefore the sovereign default risk indicated a risk in failure of the bankers that could not be specifically measured. The main reason for the reduction in the lending of the inter-banks after the crisis of the global finance of the year 2008-2009 (Frankel, & Saravelos, 2012) and the inter-bank money market migration on to the central bank balance sheet the risk of bank failure. The monetary union financial crisis an added risk that the union might split up, for example one or two members of the union may decide to walk out of the union. This is because there is no stipulation in the agreement on the union of European for any of the country to pull out of the Euro area (Feldstein, 2012). When the European Union treaty was prepared, an assumption was made that the area of euro would expand progressively to accommodate the entire European Union. The risk becomes more serious as there is no legal procedure for departure. In case of a departure of any of the member of the European Union, there will be need for a change in the law and the consequence will depend on how the law was changed. The issue that will be of importance is the solution or settlement of the outstanding debt. The question that may be asked is that which of the debts will be settled using the euro currency and which one will be settled using the new currency of the country that has walked out from the union. There is no assurance on how the law will be changed. However a country that pulls out of the European Union as a result of an unmanageable dept burden will try its level best to reduce the burden. Therefore, the pull out risk for the euro-denominated assets holder is the risk that the law will redenominated the assets into a different currency that proves to be value less than the euro (Bindseil, & König, 2012). The finance market is always familiar with the sovereign default risk, and the bank failure risk becomes very obvious at the crisis time of global finance. The potential in the risk of euro break-up appears in the 2010 and 2011 financial markets before falling back in 2012 following the ECB statement on the euro irreversibility (Müller, 2014), and the policy actions associated with aiming on tail risk elimination of brake-up. Conclusion The Impact of European Sovereign Debt Crisis created a lot of panic on Money Markets, which spread to affect other countries that were not part of the European Union like the USA. However the existence of the Eurosystem provided an opportunity for the continuous flow and lending of the funds. Some of the things that escalated fear around the euro system were that some of the banks were at risk however this bank were not known even though the same banks associated with others. It is this fear became grater with the financial firms thinking of the withdrawal of some of the countries from the European Union. It is necessary for countries under the umbrella of the European Union must have clear treaty regulating the withdrawal procedure. Bibliography ALLEN, W. A., & MOESSNER, R. (2012). The liquidity consequences of the euro area sovereign debt crisis. BINDSEIL, U., & KÖNIG, P. J. (2012). TARGET2 and the European sovereign debt crisis. kredit und kapital, 45(2), 135. BLANCO, R. (2001). The Euro-area government securities markets: recent developments and implications for market functioning (No. 0120). Banco de España. BURDA, M., & WYPLOSZ, C. (2012). 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