Among other things, finance is a confidence game. If lenders to financial institutions lose confidence, however irrationally, the institutions are in trouble. Axel Weber, president of the German Bundesbank, reinforced that old truth in his Saturday comments at the global central bankers’ retreat in Wyoming. He said that “a total over-reaction in the market” has led to the current credit squeeze.
For a central banker such as Weber, the current malaise is frustrating. His institution’s reach is limited to the banking sector. The authorities can help banks with everything from loans to a total rescue, but they cannot directly help the non-banks—commercial paper issuers, CLOs, CDOs, hedge funds, mortgage brokers—where the problems are concentrated. Nor should they try.
Weber can take comfort that his charges, the banks, aren’t suffering too much from the lack of liquidity. Unlike some non-banks, they don’t have to sell assets at fire-sale prices. Their problem is more of a headache than a serious wound.
Thanks to the help of central banks, the banks have been able to help non-banks with lines of credit and liquidity. The diversion of capital from more profitable investments will hurt, but only a little. The losses on actual subprime lending should also be containable.
The banks’ biggest headache is the buyout loans they have underwritten and want to sell, as much as $500 billion (Rs20.5 trillion) worth, according to Dealogic. A few months ago, CLOs and credit hedge funds would be big buyers. But these non-bank intermediaries are now squeezed. In turn, the banks will need to make some write-downs, but nothing that comes close to threatening the industry’s solvency.
For everyone concerned—non-banks, banks and central banks—such bumps should be expected to come with a reduction in the appetite for risk. The great danger is a loss of confidence in the banks themselves.
Weber and his peers have acted decisively to preclude that. And despite a few scare-mongering headlines, it looks like they have managed. For all the troubles in the fringes, the centre of the financial world is holding.