In January, we argued here that the Eurozone was facing similar money and credit market pressures as the U.S. The main argument against a credit crunch in the Eurozone despite tighter lending standards and wider interbank spread was that overall credit growth, and especially bank lending to non-financial corporates, remained elevated and healthy at around 15% annual growth.

The latest ECB data confirm however that the credit cycle has definitely turned in the Eurozone as well. In particular, bank lending to non-financial corporates peaked in May, and bank lending to other financial intermediaries slowed in June. Similarly, the July bank lending survey confirms that lending conditions remain tight but without worsening further.

Chart 1:

Source: ECB Monthly Bulletin, August 2008

In the money markets, interbank spreads widened again substantially since January and refuse to recede despite an (overly?) generous ECB collateral and term lending framework.

Chart 2: 3Month Euribor (orange) – 3Month EONIA Swap Rate (white) (Spread in chart below)

Source: Bloomberg

Recent research in the U.S. identifies re-intermediation pressures and writedowns of off-balance sheet asset-backed securities and structures as the main driving forces of interbank spreads. The additional stress on banks’ balance sheets results in increased counterparty risk in the form of wider CDS spreads.

As of August 25, 2008, global writedowns among financial institutions were at $504bn and new capital raised was $352 since the start of the credit turmoil. Of these, writedowns among U.S. banks were $253bn ($178bn new capital), closely followed by writedowns among European banks (incl. non-EMU) at $228bn ($153bn). Writedowns among Asian financial institutions were much smaller at $23bn ($21bn).

Chart 3:

Source: ECB Financial Stability Review, June 2008

How many more writedowns and credit losses are expected, both in the U.S. and abroad? The Federal Reserve Board published a paper this month with the title: “Foreign Exposure to Asset-Backed Securities of U.S. Origin” (by Beltran/Pounder/Thomas). An analysis of the Federal Reserve’s Flow of Funds data reveals that foreigners hold about 39% of outstanding ABS backed by U.S. assets. Therefore, foreigners will bear 39 percent of any mark-to-market markdowns associated with those securities.

Consistent with the IMF’s ultimate global financial loss estimate of $1 trillion (see Global Financial Stability Review, April 2008, Table 1.1), the authors expect foreigners’ mark-to-market losses to reach $475bn. Ultimate credit losses are expected to reach $75bn. Compared to the current $250bn writedowns taken outside the U.S., it is fair to say in the words of S&P that “we’re at best maybe half-way through this cycle.”

Charts 3 and 4 give a sense of the potential loss distribution among EMU and non-EMU banking sectors. Given current writedowns and cross-border banking flows, most of the pressure from U.S. originated assets lies on UK and Swiss banks more than on the Eurozone among whose members German, Dutch and French banks bear some exposure. This discrepancy between EMU bank losses so far and Eurozone interbank spreads might lie at the heart of the ECB’s regulatory arbitrage suspicions with respect to non-EMU banks. That said, the Eurozone has plenty of housing and economic problems of its own as the record €49bn ECB lending to Spanish banks reminds us.

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