Working Paper Series no. 687: Bad Sovereign or Bad Balance Sheets? Euro Interbank Market Fragmentation and Monetary Policy, 2011-2015

Interbank market fragmentation can have significant welfare costs: by affecting the funding capacity of banks, it can hinder the smooth transmission of monetary policy and thus impair the provision of credit to the real economy. In the euro area, interbank fragmentation has been fuelled by the sovereign-bank nexus: in peripheral countries (Greece, Ireland, Italy, Portugal, Spain and Cyprus or GIIPS), banks have been affected by their own governments’ debt problems and vice-versa.

We can distinguish two sources of fragmentation in the eurozone. First, while banks can freely provide financial services in all member countries, their domestic sovereigns are primarily responsible for bailing them out in case of failure. Bank funding could thus be negatively affected by pure home country sovereign risk. This is the sovereign-based source of fragmentation. Second, even if banks can serve the whole European market, they are overly exposed to their domestic economy, which makes balance sheet quality depend on local economic conditions. This is the balance sheet (credit risk) source of fragmentation. Indeed, when systemic risk is high and contagion very likely, as in 2011-2015, lenders could react to country risk rather than to idiosyncratic counterparty risk.

As shown in the figure, throughout 2011-2015, banks headquartered in peripheral countries paid on average higher rates (volume-weighted) than non-peripheral banks. The difference was especially large in December 2011, before the Eurosystem’s first 3-years liquidity refinancing operation, and before the announcement of the Outright Monetary Transactions (OMT) programme in August 2012.

This article tackles the following research questions. What determines the access and the interest rates served in the euro area interbank market in 2011-2015, what are lenders pricing in? What is the relative role of the credit risk in bank balance sheets compared to the risk of sovereign dependence (because of the implicit guarantee of sovereign bailout)? How do lending conditions in the interbank market interact with monetary policy?

We provide a simple theoretical model to analyse the effects of balance sheet and sovereign risk on interbank market access and interest rates. The model takes into account the interaction between interbank lending conditions and central bank liquidity provision, including via non-conventional monetary policies. We then test the model predictions using granular interbank lending data and detailed information on banks’ exposures, cross-border and cross-sector.
We highlight three findings. First, all other things equal, high non-performing loan (NPL) ratios on GIIPS assets hinder access of non-peripheral banks to the interbank market during all three monetary policy periods: higher NPL ratios on GIIPS assets decrease the probability to find a lender in the market. Second, from mid-2011 and until the OMT, a non-peripheral bank pays more for interbank loans the larger its exposures to GIIPS sovereigns. But the OMT closes this channel of shock transmission.
In fact, after the OMT announcement, also the selection effect due to high NPL on GIIPS assets, while still significant, becomes much weaker. Third, the OMT announcement reduced sovereign-based and balance sheet fragmentation alike: it reduced country-premia paid by GIIPS borrowers, but it also affected lenders’ pricing of counterparty credit risk.