PARIS (MNI) – Financial markets are not yet completely back to
normal, and the European Central Bank must still keep a watchful eye and
remain active in the market, the ECB said in its fourth annual Report on
Financial Integration, published Monday.

The reported noted that as market conditions gradually normalized
during last year and “especially in 2010,” the market segments that had
suffered most — namely, inter-bank money markets — were quickest to
return to pre-crisis levels of cross-border integration.

“However, since the functionality of European financial markets has
not yet been fully restored, vigilance and the ECB’s active presence in
the market are still essential,” it said.

The report noted that a significant improvement, particularly in
inter-bank money markets, occurred after the ECB’s first 12-month
refinancing operation last June, which pumped an unprecedented E442
billion into the system and pushed overnight inter-bank rates down
sharply toward — and in some cases below — the ECB’s deposit rate.

The crisis-induced divergence of inter-bank rates across countries
has diminished significantly since the second half of 2009, reflecting
the effect of the ECB’s generous liquidity policies, the report noted.
However, in terms of actual volumes, “a retrenching towards domestic
funding was observed,” it added. “Indeed, the limited effect of policy
measures on quantities, as compared with prices, indicates that the
impact of the crisis on money market integration is still far from
coming to an end.”

Moreover, despite the improvement, the divergence of money market
rates “remained significantly above the levels that characterised the
pre-crisis period,” the central bank continued. “This suggests that
market functioning remains far from its pre-crisis levels.”

The ECB added: “It is hard to predict at this stage how lasting the
negative effect of the crisis on the activity of secured and unsecured
money markets will be, especially considering that the liquidity
provision by the Eurosystem will play less of a supporting role in the
coming months.”

The report also noted that the ECB’s decision last May to purchase
E60 billion worth of covered bonds had helped stimulate more primary
market issuance and pushed yield spreads sharply lower. Cross-country
dispersion of covered bond yield spreads also declined rapidly in the
second half of last year, though they have stagnated since autumn at
around 80 basis points above German 5-year government bonds.

The report urged further integration of covered bond markets — in
particular, a homogenization of common standards and definitions across
countries — “in order to broaden the investor base, but also to
strengthen covered bonds further as a separate asset class.”

–Paris Newsroom, +331-42-71-55-40; bwolfson@marketnews.com

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