August 29, 2014 / 9:17 AM / 3 years ago

UPDATE 3-Negative euro overnight rates show cracks in banking system

5 Min Read

* Banks paying to lend top-rated peers money

* Peripheral banks shut out of money market

* Cash-rich banks have no alternatives

* Eonia could fall even further, say strategists (Recasts)

By John Geddie

LONDON, Aug 29 (Reuters) - Overnight bank-to-bank lending rates turned negative for the first time, data showed on Friday, highlighting the acute lack of confidence in the euro zone banking system before the ECB health checks due next month.

Banks prefer to pay to lend to their top-rated peers rather than to banks in the euro zone periphery, which need cash and depend on the European Central Bank for liquidity, even if it means they miss out on a profit.

"The bigger, healthier banks, the majority of which are in core countries, don't have any problem with inter-bank lending and are particularly long in cash at the moment," said Kenneth Dickson, investment director at Standard Life. "... Smaller banks, particularly within the periphery, are probably not able to attract much money from the interbank market."

Euro overnight interbank lending rates have been falling for months, a reflection of the ultra-loose monetary policy the ECB has put into effect to try and stave off economic stagnation and the threat of deflation.

The fall below zero highlights one of the root causes of the bloc's economic malaise - the reluctance of banks to lend.

The latest data show lending to companies and households continues to decline. Getting banks to carry out transactions with one another would be considered a step in the right direction.

Even that seems some way off.

Top-tier banks in countries like Germany and the Netherlands face problems managing an excess of cash when they are not prepared to lend it to their weaker peripheral peers.

Regulatory and internal guidelines mean banks cannot sit on piles of liquidity overnight, but as of June the European Central Bank has also started charging banks that deposited this money at the central bank.

Some banks with large amounts of cash see taking a loss on interbank transactions as their only option, especially as geopolitical tension and speculation about further ECB easing have driven the yields on other "safe" investments negative. German bonds with maturities out to four years have yields below zero.

"Some banks have just realised that without alternatives, you just have to take the hit and transact at negative rates," said Commerzbank's money markets strategist Benjamin Schroeder.

Further Falls Ahead

For banks on the periphery that are shut out of wholesale money markets, the ECB holds weekly tenders offering cheap short-term cash. Starting next month, it will also offer banks a fresh set of long-term emergency loans (TLTROs).

In a note to clients, RBS said negative Eonia rates may reflect the fact that few peripheral banks on the Eonia banking panel were reporting transactions. As they would pay more to borrow, that would have pushed up the fixing.

Of the 35 on the Eonia panel, only 11 are from the so-called peripheral countries of Spain, Italy, Greece, Portugal and Ireland. That is a fraction of the 130 banks subject to the ECB's asset-quality review.

Some money market watchers predict Eonia could fall even lower in the months ahead, as new liquidity provisions from the ECB take effect.

JPMorgan sees Eonia falling from current levels of -0.004 percent to as low as -0.050 bps in the months ahead as excess liquidity - which has historically put downwards pressure on Eonia rates - rises after the TLTROs.

Others see the prospect for further ECB rate cuts as early as next week, as a stagnating economy and disinflation ramp up the pressure on the central bank to act.

"One factor the Eonia market is not yet priced for is the potential for an ECB rate cut next week," said RBS in a note to clients. "Any easing is a finely balanced decision but any cut would probably push fixings lower."

Euro zone inflation dipped to 0.3 percent in August, in line with the expectations of economists polled by Reuters. (Additional reporting by Marius Zaharia; Editing by Crispian Balmer, Larry King)

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