Thursday, 9 October 2008

We need a market based approach to the credit crisis

We keep hearing that commercial banks will not lend to each other, but that is not quite true. When the crisis started a year ago, spreads in the interbank rose sharply. These higher rates reflected a repricing of risk. Banks were willing to lend to each other but needed higher rates of return in compensation of the increased risk of default.

Central banks were not too keen this market based outcome. Instead, they tried to work around it. The Federal Reserve, the Bank of England, and the ECB cut their policy rates and opened up emergency credit lines at below market interest rates. Over time, these credit facilities have grown and in the post-Lehman world, the outstanding stock of central bank credit has reached astronomical levels.

How does this approach foster interbank borrowing? If the central bank is providing unlimited amounts of credit at extremely low interest rates, what is the incentive for a commercial bank to go to the interbank market and pay a higher rate? In effect, cheap central bank credit has crowded out the private interbank market. Or to put it another way, central banks are offering subsidized credits, and this distortionary price setting has destroyed the interbank market.

If the interbank market is ever to recover, central banks are going to have reduce the amount of credit they offer banks. Otherwise, central banks will become the only source of short-term funding. In fact, this is a reasonable description of the current situation.

The central banks are now stuck in a hole. Despite yesterday's interest-rate cuts, the interbank market shows no sign of recovering. According to Bloomberg, the cost of borrowing in dollars for three months in London soared to the highest level this year. Libor rate for three-month loans rose to 4.75 percent today, the highest level since last Christmas. Remember that the Federal Funds rate is only 1.5 percent. At the same time, and commercial banks are stockpiling huge amounts of cash, which is offering a zero rate of return, while other banks are borrowing cheaply from the central bank.

Perhaps a more sensible strategy would be for the central banks to offer unlimited credit lines at interest rates fractionally above the market determined interbank rate. This would encourage banks to return to the interbank market.

Slowly but surely, we would see the market return to normal as banks regain confidence in each other. Any bank deemed an unacceptable risk could still get credit from the central bank, thus preventing a bank run. Moreover, if a bank continued to seek central bank credit, this would be a powerful signal that the bank needed something more than just a credit line, like for example, a capital injection, or even full nationalization.

Without a market-based approach to this problem, central banks will be trapped in a permanent funding crisis, with banks begging huge amounts of low cost credit.


Nick Drew said...

too right !

Anonymous said...

Central banks have gone too far. They are lost in a fog.

Mark Wadsworth said...

The solution is far simpler than that, and the State should keep out as far as possible, except to start supervising banks properly - not regulating, mind you, I mean supervising, having quiet words in ears etc.

Nobody wants to lend to banks because they are 'undercapitalised'. What does this mean in practice? It means that total liablities are perilously close total assets - especially as we know banks are overstating the value of some of their dodgier investments.

The 'capital' is just a balancing figure, really.

On the liabilities side we have customers' deposits, shorter term 'money market' stuff and longer term bonds.

To recapitalise banks, all they have to do - at gunpoint if necessary - is to cancel some of their longer term debts and replace it with share capital, a so-called 'debt-for-equity-swap'.

Hey presto, problem solved. The bondholders who get given shares can always sell their shares if they need cash - the total value of the bonds and shares, taken together, will probably be slightly enhanced by the move.

Worked example applied to Bradford & Bingley here.

As to bonuses, these are A Good Thing as far as HM Treasury is concerned - the corporation tax on negligible profits is negligible - but we know that bank managers overstated profits and then paid themselves huge bonuses taxed at effective rate 47% (including Employer's NI).

The real losers from the bonus culture are the shareholders. The problem here is that most shares are owned by 'institutions' who are in cahoots with boards of plc's and vice versa. Again, this is easily fixed - see here.

Land values can be kept low and stable by introducing land value tax (and scrapping all other property or wealth related taxes - I am a small government, low tax kind of chap).

There. All sorted.

Anonymous said...

The reason the market isn't recovering at any great rate is that the underlying problems which caused all this, namely bad loans being traded around all over the place so nobody knows who owns which deadbeat worthless paper, has not yet been resolved.

What needs to happen is some state-forced disambiguation of the credit markets, preferably starting with the USA. That also needs the immediate repeal of the original market-distorting regulations which forced banks there to loan to deadbeats and then try to cover up the lousy loans.

This process will hurt a lot of banks, but the pain is going to be short-term rather than a long, drawn-out malaise.

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