Sorry to be brief, but a good article by Charles Goodhart, emeritus professor at the London School of Economics, acknowledges that lack of transparency and dubious ratings have played a major role in the current credit crisis. Unlike most other writers, however, he points to a looming third culprit: insufficient bank capital.
Observers may find that to be an odd charge, since bank regulators and banks themselves assert that they are well capitalized. Goodhart highlights contingent claims (read all those backup lines of credit to asset backed commercial paper vehicles) as the immediate source of pain, but stresses that capital will soon be an issue, as banks take losses and as assets on their balance sheets are downgraded (low rated assets require more regulatory capital.
Goodhart isn’t alone in pointing to the largely neglected issue of capital. James Hamilton also discussed the inadequate capitalization of Fannie Mae and Freddie Mac and their role in the crisis in his remarks at Jackson Hole. Although the two issues don’t seem directly related, they illustrate a common failing in policy discussions: a tendency to look to interest rate and liquidity fixes to problems that also have a regulatory component.
From Goodhart:
…. 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 tiering 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.
