Volatility in financial markets is often a strong indicator of risk and risk sentiment. Both the equity and debt markets have recorded increased volatility over the past month, and particularly so more recently. Global equity markets have at times seen deep falls in indices followed by large but short-lived leaps. The rebound, although short-term, has provided respite to the growing concern towards the fragility of financial markets. However, although the immediate gloom may be lifted with strong rises, the underlying risks have not gone away. There remains a clear probability of risk that the markets are awaiting the next large event which could erase all the recovery seen over the past year or so.
What is evident is that the markets are moving very sharply on announcements which, in itself, can indicate uncertainty, something inherently investors do not like. Equities recently moved higher following a slight rise in the value of the euro and an improvement in the main credit markets. The turnaround in sentiment was largely spurred on by the announcement by China, as well as Kuwait and Korea, that it would continue to purchase euro assets, contrary to the belief that it was reviewing its holding of eurozone debt securities, including both government paper and corporate securities.
This announcement aided the credit markets where yields fell. The US dollar Libor rate was a key beneficiary of this positive news, as the yardstick stabilised for the first time in a month. The US dollar Libor rate is one of the main indicators on bank lending risk and has widened noticeably recently. The market watches the rate carefully as it provides a view of risk appetite and liquidity, the latter including both liquidity self preservation and overall market funding conditions. Dollar Libor rates gauging stress and risk within the interbank lending market are still at close to a year's high. The iTraxx Senior Financials Index – an indicator of banks' riskiness – remains at close to its high for the past 12 months.
The condition of the wholesale funding markets for banks has enormous implications for financial institutions as funding can either quickly tighten or become very costly, and in turn presenting difficulties for those either reliant on it or in need of rolling over facilities. In turn, it has a direct impact on the real economy as financing tightens and growth is restricted. The market has a noted skill in identifying those banks which are facing challenges, making it more difficult for them to secure financing. The Libor rate is still considerably below the peak reached during the Lehman crisis, but it certainly has overtones of the credit market crisis two tears back. The collapse and meltdown in the interbank market was the precursor of the global financial crisis.
The credit markets are still maintaining a very watchful eye. Although the announcement by China on euro assets was beneficial, it certainly has not removed any of the other main risk issues facing both the euro and the eurozone. Country risk for the weaker euro members remains an important issue. Debt profiles remain precarious for some and combined with weaker growth prospects, more problems could be on the horizon. The euro will continue to weaken throughout 2010, even with the supposed inherent support of the Chinese, the world's largest holder of foreign exchange reserves. The economic and debt challenges facing Europe and, in turn, weakness in the euro, will see credit conditions within the eurozone, and Europe generally, tighten. This will in particular make the US dollar funding market more expensive and difficult for the eurozone, and even more so for its banks.
The vulnerability of the eurozone and its currency was made evident through the recent downgrading of Spain's sovereign credit rating. Spain is facing a number of large problems, from high debt and fiscal deficits, weak growth, high unemployment and a collapsed property market. Most of the country's banks are very vulnerable to the domestic economic environment, particularly in regard to increasing levels of loan defaults and decreasing value of collateral held. By no means is Spain in the worst financial condition in Europe, but the collective positions of all those in vulnerable positions may be the catalyst for a market-wide event.
The impact on the global economic recovery would be substantial, placing any semblance of a recovery on hold for some time. The feared double dip recession for many economies could come to fruition. At the same time, inflation for some large Western economies remains a possibility with the ever present risk of stagflation.
What are the implications for banks and financial institutions in the region? Firstly, their priority must be to remain as liquid as possible, focusing on building fortress-type balance sheets with low leverage, strong cash flow and high liquidity. Bank lending and wholesale funding are and will remain tight for some time. There was a slight improvement in the funding market in the first quarter of 2010 for GCC banks, but since then it has tightened. This very much reflects the volatility in world markets and the risk aversion of large international banks which are the main players on the wholesale funding markets.
Gulf banks on the whole have the benefit of being more focused on core customer deposit funding and this must remain the strategy. Nonetheless, the lack of additional and diversified wholesale funding opportunities will have an impact on regional banks' opportunity and capacity to grow asset bases. For this reason in particular, growth in balance sheets and also earnings is likely to remain modest this year. Those banks with more liquid balance sheets and a good funding profile will definitely be at a competitive advantage. On the whole, this will be the larger banks with significant retail customer deposit bases.
- The author is a US-based commentator on business issues