Monthly Briefing on the World Economic Situation and Prospects, No. 40

The sovereign debt crises continue to place stress on European banks. The value of government bonds has fallen with the lowering of?credit ratings for many European countries. This has eroded the balance sheets of banks holding substantial amounts of those assets.?Subsequently, banks have cut lending ? especially to other banks ? and have opted instead to deposit money with the European?Central Bank (ECB), even more so in the final months of 2011. As a result, liquidity available in the European banking?system has dried up, reducing the lending available to households and businesses and inducing investors to move money out of the?euro and into other currencies which are perceived to be safer, including the United States dollar, the Swiss franc and the Brazilian?real. These effects may have been exacerbated by the increase in bank capital requirements stipulated by financial regulators. In order?to comply, European banks seem to have further tightened commercial lending and have sold assets, especially those held in operations in Eastern Europe and Latin America.

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In December 2011, the ECB stepped in to avert a credit crunch. Because its statutes do not allow the ECB to act as a lender of last?resort to sovereigns, it launched a new phase of the Longer-Term Refinancing Operation (LTRO). The LTRO supplies private banks?with unlimited three-year loans at an interest rate of 1 per cent, well below what most governments need to pay when borrowing in?private capital markets.

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