With the credit crunch now in its eighth month, central banks are considering more unorthodox ways to restore order to the markets. Cris Sholto Heaton reports.
What have central banks done so far?
The US Federal Reserve has been the most active. As well as slashing interest rates, it has set up a number of new facilities to improve market liquidity.
These include the Term Auction Facility (TAF) and the Primary Dealer Credit Facility (PDCF), which let banks and primary dealers borrow money from the Fed by pledging assets as collateral. The Term Securities Lending Facility (TSLF) is similar, except that the borrower gets Treasuries (US government bonds) in exchange for the assets it pledges, instead of cash. And, of course, the Fed also prevented Bear Stearns from going bankrupt by organising a takeover by JPMorgan, including providing a $29bn guarantee against some of Bear Stearns’ riskiest assets.
The European Central Bank, the Bank of England (BoE), and the Bank of Japan have all used their regular channels to inject more cash into the market, while the BoE has also cut interest rates, not to mention providing the life-support system for Northern Rock.
Have these measures worked?
Well, large-scale panic has been averted so far. There have – as yet – been no more bank runs like those that made Northern Rock and Bear Stearns unviable. But the situation is not back to normal – far from it. Spreads between central-bank base rates and interbank lending rates remain high because institutions aren’t sure of each other’s creditworthiness and don’t want to lend to one other. This means that the markets for many debt-based assets are still frozen.
With many banks undercapitalised as a result of writedowns on subprime mortgage assets, their main aim now is to improve their balance sheets, not deal in assets of questionable quality. Until all this improves, the credit crunch will endure.
So what happens now?
Banks will have to raise more capital, so we can expect to see more dividend cuts and attempts at raising capital from investors. Swiss bank UBS announced a $15bn raising after its latest writedowns, and Lehman Brothers has passed around the begging bowl for $4bn. This is bad news for shareholders who see their equity diluted, but it helps put the banks back on a stronger footing – which is much more important.
But allowing the crisis to fix itself through private-sector recapitalisations will take time, so the Fed and other central banks are considering unusual methods to resolve problems sooner rather than later.
What other options are there?
A number of steps were discussed at the Financial Stability Forum last week. These include state-supported purchases of mortgage-backed securities (MBS), the temporary relaxation of capital requirements and accounting rules, simultaneous and detailed disclosure of where the major banks stand and public sector recapitalisation of troubled banks.
What are the pros and cons of each?
Purchasing MBS would take the securities out of the hands of troubled banks and provide them with more capital. It would also put a floor under prices in the market, which might help to unfreeze it. On the downside, it would interfere with the process of setting appropriate prices in these markets. Suspending rules would prevent the banks having to carry out rushed recapitalisations or asset firesales, but risks damaging market confidence further.
On the other hand, a declaration of each bank’s position would probably be calming, since there would be much more certainty about everyone’s situation. But it would have to be accompanied by a rescue package for anyone shown to be in serious trouble. The Fed has been talking to regulators in Scandinavia about their banking bailout of 1991-1993, which led to forced nationalisations of undercapitalised banks.
Can a public bailout ever be good news?
In some ways, yes. Norway is seen as an example of a good bailout; shareholders received nothing, senior management was fired and the process was quick and efficient – unlike the drawn-out support of Japan’s banks. This helps curb the moral hazard of bank bailouts – that is, the danger that by saving banks that have taken undue risks, you merely encourage others to do the same.
However, taking banks under Fed control could be an administrative headache and nationalisation is a dirty word for many in the US, so the idea of the Fed forcibly buying out shareholders wouldn’t go down too well. This is probably why the rescue of Bear Stearns was conducted through JPMorgan, so that it could be presented as at least a semi-private sector operation. But it’s doubtful if that process could be repeated if another bank failed – hence the new proposals.
Are the Fed’s actions inflationary?
So far, no. Loans through the TAF and PDCF have been sterilised by the sale of treasuries from the Fed’s balance sheet. In other words, the Fed is not adding to the cash in the system, it’s merely trying to direct it where it’s most needed. (The TSLF serves a similar purpose – directing treasuries to market participants who need them).
However, the Fed only has a limited number of treasuries – about $629bn at present, but with $200bn earmarked for the TSLF – and if these were exhausted, it would be unable to continue sterilising. This may be why it’s considering other ways to improve liquidity – that and the fact that the current measures are keeping the banking system alive, but not fixing the underlying problems.