Capital, not liquidity, is the problem
Tuesday, 18 September 2007
Charles Goodhart
THERE are several odd features about current financial difficulties. They appear to have been initiated by relatively minor problems, rising defaults in a subsection of the US housing market, when the world's economy was otherwise in splendid shape. If this is enough to cause the financial system to have a "heart attack", there must be underlying systemic problems. What are these?
First, there is a lack of information and transparency. Regulators, in their financial stability reviews, have been complaining for years that financial innovation has made it difficult for them to observe where risk has become concentrated. What was overlooked was that it made risk just as difficult for anyone else to observe. So once risk aversion started rising, everyone came under suspicion. How does one know how many structured investment vehicles your bank has tucked away off-balance-sheet?
Second, one, usually valuable, source of information, ratings agencies, has been criticised for failing to provide good-enough up-to-date ratings assessments, and many investments are based on agencies' ratings rather than on direct credit analysis. When ratings come under suspicion, entire funds and institutions likewise become suspect.
Rather than a blanket call for regulation, we should ask what information is required to keep markets operating efficiently, and how to get it.
The third issue is that, just as the central bank is lender of last resort to banks, so banks are lenders of last resort to capital markets, especially to their own clients in such markets. When those markets seize up, whether private equity deals or asset-backed commercial paper (ABCP), contingent claims on banks become transformed into huge loan obligations. Such sudden extensions of credit can cause banks to reach prudent lending limits quickly. Whether regulators have had sufficient information on, and control over, such contingent commitments is a question needing answers.
The problem is not the availability of cash (liquidity in that sense). In order to keep market rates close to the policy rate, central banks have to inject whatever the banking system wants. Indeed Barclays has stated that it is "awash with cash", as are probably most other commercial banks. Nor does it matter in which market the central bank operates; as long as the central bank wants short rates at a particular level, it must inject a given quantity of cash; whether by operations in the overnight, one-week, three-month or longer-term gilt market is a second-order issue. Of course, a central bank could target the three-month London interbank offered rate, rather than a one-week or overnight rate, but doing so now would be tantamount to a large cut in the existing policy rate.
Nor is it a good idea for central banks to widen the range of assets acceptable as collateral. Central banks want commercial banks to hold a stock of undoubtedly liquid assets. If every time a market seizes up, the authorities move to liquefy the assets involved, in this case ABCP, what incentive is left for banks to hold lower-yielding Treasury or government bonds? A liquidity bail-out has just as severe a moral hazard consequence as a capital bail-out.
Meanwhile the contingent commitments are coming home to roost. The financial system needs the banks to lend more, possibly much more, if only temporarily. Banks are currently struggling to find the necessary funding. No wonder they will not lend to each other; they need all their spare resources for themselves. If the primary reason for the high interest rates in the three-month interbank market had been counter-party credit risk, we should have seen much more tiring of rates, between different categories of bank, than has been reported.
But in the longer term the underlying problem will become capital availability, not funding problems and certainly not cash liquidity. Worsening risk raises capital adequacy requirements, and lower profits and higher write-offs reduce the capital base. The Basel II framework for regulating banks' risk capital will raise the sensitivity of capital adequacy ratios to risk. When it is introduced in Europe at the start of 2008, many banks will find their prior cushions of capital, above the required limit, eroding fast. That could extend and amplify the crisis.
Several of my colleagues at the financial markets group foresaw the dangerous pro-cyclicality of Basel II. Our foreboding may turn into reality sooner than we expected.
(The writer is emeritus professor of banking and finance at the financial markets group, London School of Economics.)
..........................................
— FT Syndication Service
THERE are several odd features about current financial difficulties. They appear to have been initiated by relatively minor problems, rising defaults in a subsection of the US housing market, when the world's economy was otherwise in splendid shape. If this is enough to cause the financial system to have a "heart attack", there must be underlying systemic problems. What are these?
First, there is a lack of information and transparency. Regulators, in their financial stability reviews, have been complaining for years that financial innovation has made it difficult for them to observe where risk has become concentrated. What was overlooked was that it made risk just as difficult for anyone else to observe. So once risk aversion started rising, everyone came under suspicion. How does one know how many structured investment vehicles your bank has tucked away off-balance-sheet?
Second, one, usually valuable, source of information, ratings agencies, has been criticised for failing to provide good-enough up-to-date ratings assessments, and many investments are based on agencies' ratings rather than on direct credit analysis. When ratings come under suspicion, entire funds and institutions likewise become suspect.
Rather than a blanket call for regulation, we should ask what information is required to keep markets operating efficiently, and how to get it.
The third issue is that, just as the central bank is lender of last resort to banks, so banks are lenders of last resort to capital markets, especially to their own clients in such markets. When those markets seize up, whether private equity deals or asset-backed commercial paper (ABCP), contingent claims on banks become transformed into huge loan obligations. Such sudden extensions of credit can cause banks to reach prudent lending limits quickly. Whether regulators have had sufficient information on, and control over, such contingent commitments is a question needing answers.
The problem is not the availability of cash (liquidity in that sense). In order to keep market rates close to the policy rate, central banks have to inject whatever the banking system wants. Indeed Barclays has stated that it is "awash with cash", as are probably most other commercial banks. Nor does it matter in which market the central bank operates; as long as the central bank wants short rates at a particular level, it must inject a given quantity of cash; whether by operations in the overnight, one-week, three-month or longer-term gilt market is a second-order issue. Of course, a central bank could target the three-month London interbank offered rate, rather than a one-week or overnight rate, but doing so now would be tantamount to a large cut in the existing policy rate.
Nor is it a good idea for central banks to widen the range of assets acceptable as collateral. Central banks want commercial banks to hold a stock of undoubtedly liquid assets. If every time a market seizes up, the authorities move to liquefy the assets involved, in this case ABCP, what incentive is left for banks to hold lower-yielding Treasury or government bonds? A liquidity bail-out has just as severe a moral hazard consequence as a capital bail-out.
Meanwhile the contingent commitments are coming home to roost. The financial system needs the banks to lend more, possibly much more, if only temporarily. Banks are currently struggling to find the necessary funding. No wonder they will not lend to each other; they need all their spare resources for themselves. If the primary reason for the high interest rates in the three-month interbank market had been counter-party credit risk, we should have seen much more tiring of rates, between different categories of bank, than has been reported.
But in the longer term the underlying problem will become capital availability, not funding problems and certainly not cash liquidity. Worsening risk raises capital adequacy requirements, and lower profits and higher write-offs reduce the capital base. The Basel II framework for regulating banks' risk capital will raise the sensitivity of capital adequacy ratios to risk. When it is introduced in Europe at the start of 2008, many banks will find their prior cushions of capital, above the required limit, eroding fast. That could extend and amplify the crisis.
Several of my colleagues at the financial markets group foresaw the dangerous pro-cyclicality of Basel II. Our foreboding may turn into reality sooner than we expected.
(The writer is emeritus professor of banking and finance at the financial markets group, London School of Economics.)
..........................................
— FT Syndication Service