ANNUAL REPORT 2008 - Polymer Bank Notes of the World

was driven mainly by developments inovernight deposits, for which a negative annualflow was observed in the third quarter. Overall,M1 growth in 2008 continued to be influencedmainly by the dampening effect resultingfrom the rising opportunity cost of holdingM1 associated with the increases in interestrates as of December 2005. That effect wasprobably partially offset by the desire to holdM1 as a buffer in the context of the financialmarket turmoil. From mid-September onwards,however, holdings of M1 appeared to gain somemomentum following the increase in financialtensions (see Box 2).Box 2DEVELOPMENTS IN THE EURO AREA MONEY MARKET IN THE CONTEXT OF THE FINANCIAL TURMOILThe financial turmoil that started in August 2007 continued into 2008 and intensified in theautumn of that year, posing considerable challenges as regards the functioning of the interbankmoney market and the Eurosystem’s liquidity management. This box describes the developmentsin the main segments of the euro area money market in 2008, relates developments to underlyingfactors in the global financial markets and explains the Eurosystem’s decisions on liquiditymanagement in response to the tensions.The origins of the crisisIn August 2007 the global financial system entered a period of considerable turbulence,triggered primarily by the impact that rising delinquency rates for US sub-prime mortgages hadon the valuation of a broad class of mortgage-based securities. The complexity and opacity ofthe structured securities, together with the absence in many cases of a market price for theseinstruments, made these products difficult to value, with adverse implications for the evaluationof banks’ overall balance sheets. More precisely, investors retreated from structured investmentvehicles (SIVs) and conduits that were based on asset-backed securities derived from thesecuritisation of US sub-prime mortgages and became reluctant to hold or roll over assetbackedcommercial paper (ABCP) issued by these investment vehicles. As a consequence,banks faced the risk of having to reintermediate such SIVs onto their balance sheets and/orprovide funding to SIVs and conduits issuing ABCP. As banks became increasingly concernedabout their liquidity and balance sheets, they became less willing to provide funds to otherbanks. The complexity and opacity of many of these products increased banks’ reluctanceto participate in interbank transactions, both because banks doubted the creditworthiness oftheir potential counterparties and because banks were uncertain about their own exposures(with regard to capital and liquidity) derived from conduits and SIVs. As a consequence,banks hoarded liquidity. Liquidity diminished in the interbank money market, impairing thefunctioning, in particular, of the longer-term unsecured deposit markets (owing to banks’preoccupation with the possible risk exposures of their counterparties), non-government repomarkets, commercial paper markets and foreign exchange swap markets.Although considerable progress has since been made in identifying and valuing exposures to thecomplex securities at the epicentre of the market turbulence, there is still uncertainty about thelosses that will ultimately be suffered by investors and financial institutions across the globe.Money markets therefore remained under strain throughout 2007 and 2008.ECBAnnual Report200831