Wednesday, October 1, 2008

Wholesale bank funding

The 160-200bp and above margin (overnight US$ LIBOR at 6.78%, highest since 2001) on interbank lending is explained by commentators as banks refusing to lend to each other directly and/or hoarding cash for fear of counterparty risk or simply because they are cash-flow constrained. If interbank lending has dried up, then what is LIBOR other than an illiquid market risk price? And if banks who are normally herd animals will not flock together and make a show of confidence in each other, how can confidence be won externally? Kenichi Ohmae in today's FT says banks are exhibiting wolf-pack syndrome, "good at attacking prey as a team, they turn on the weakest of their cohort should hunger prevail!"
One answer is that banks are trying to replenish their reserves. Swapping securities of any sort for treasuries is ideal, because treasuries are almost zero counterparty risk requiring almost no contingenct reserve and hence much better than lending to other banks (not least when it can cost over 6% to ensure a loan to a reputable bank).
The Central banks are therefore today the preferred lender of first resort and in response to the demand are pumping money into the banks from time to time, not smoothly or regularly; like turning over an unresponsive engine when actually the plugs need cleaning and refuse to spark. One might be forgiven for thinking that in a liquidity crisis banks could recognise a mutual self-interest in simply resuming lending to each other at near to normal rates, and that their industry associations or the central bank should get them together and order them to agree to do so directly rather than indirectly via the central bank. After all, in the words of Martin Wolf (FT today) "we are witnessing the disintegration of the financial system". he also picked up one of my observations that some US conservatives are seeking a replay of the Great Depression without this time a New Deal. Is it that banks won't lend enough, or that they can't lend enough? One view is that banks have become deeply distrustful of each other, and have gambled away their most important asset: trust in each other. Another view is that strong banks are squeezing weaker ones and looking to buy them cheap. The central banks and the banking associations should surely at least be able to re-establish that trust if only at the level of short term interbank lending and borrowing. Instead they are trying to do it less directly via market mechanisms, a clearing and transparant swap system for 'troubled assets' (e.g. TARP), by adding flexibility to fair value pricing, and in extreme instances by forcing mergers or taking equity stakes. A further more drastic measure being considered is to force the break-up of different parts of large bank groups - funds management, proprietary trading, traditional banking, insurance, complex structured products and to bring OTC markets on-exchange, such as proposed by Prof. Tim Congdon and others.
This is being resisted by the likes of the ISDA who hope that creating clearing houses for OTC trading will suffice to net off credit derivatives and provide transparancy. Goldman, Deutsche and JPM are hoping to launch such a clearing house in November. Gerald Corrigan, MD of Goldmans and ex-President of the NY Fed, and Chair of several regulatory iniatives places much hope in CMPG III Report's new methodology for execution of close-out against a CDS defaulted counterparty, which has already netted $14tn off the $30tn book at the Depository Trust Company between April and August. Bank of America analysts estimate that liquidity measures by central banks will add nearly $500bn to banks' capital reserves in the coming weeks rising to $630bn around year end when bank borrowing demand is high.
The engine of the money market is banks borrowing and lending to each other, using CP, repos and similar instruments, benchmarked (i.e. priced over and above) to the London Interbank Offered Rate (LIBOR). Today, there is interbank borrowing and lending, but it is almost all via the central bank. Banks are hoarding cash at the central bank, buying treasuries and borrowing from the central bank, which is acting like an exchange, not just as the manager of the money supply (accepting securities as collateral for loans, or buying the securities for money). The liquidity infusions by central banks appear to taxpayers to be diverting their hard-earned tax into aid for banks and away from more deserving spending programmes, and has also been characterized as not unlike giving prescription methadone to heroin addicts, although in fact this is mistaken; the money is not free, not something for nothing.
In Germany there is no sign of a credit crunch according to the country's BdB private banks' association on 18 Sept. One reason given is the memory of 1931 when a Berlin bank's failure crashed the system. The German Foreign Minister has said Germany has no need of TARP. Hank Paulson has asked that other countries set up their own TARPs. The The EU Commission welcomed the bailout plan when it was announced but said that creating a TARP for the EU (or by the ECB for the Eurozone)
"not a question that falls directly under the Commission's competence." The German Chancellor, Angela Merkel, reiterated calls for more transparency and tighter regulation of markets, and is very critical of the US for failing to heed calls to improve regulation of hedge funds and implement more stringent financial controls, Although several banks have failed and Germany did grant retail investors access AI hedge funds a few years ago, and some extended mm funds have failed and money market conditions were restored only by heavy borrowing from the ECB’s lending facility against collateral that is not viable in the capital markets, just as in the US, and the unsecured lending rate EURIBOR remains high, German politicians are nevertheless wary of TARP and have ruled out any participation.
Counterparty risk reflected in the interbank lending rate was tackled in Ireland by the decision to guarantee all deposits(400bn or more, equal to about twice GDP). This is having a ripple effect to other countries. Senior bankers in the UK are pressing the Government to guarantee in full more than £2tn of deposits (1.5 times GDP), protecting all UK bank depositors completely, saying that PM Brown's pledge to raise the cap on savings protected to £50,000 is not be enough to restore confidence (The Independent today).
It seems to me that banks in Europe should be getting together under some auspices such as their banking associations and hammer out agreements to ease liquidity constraints between them directly and even work on creating their own mini-TARPs.
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