Press banks to build more capital

Press banks to build more capital
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First Published: Fri, Apr 11 2008. 11 23 PM IST
Updated: Fri, Apr 11 2008. 11 23 PM IST
Is the worst over? That will be a big talking point when finance ministers, bankers and central bankers gather in Washington this weekend for the International Monetary Fund (IMF) and Group of Seven meetings.
The answer to the question depends on which crisis one is talking about. If it is subprime, the answer is probably yes. If it is the real economy, the damage has barely started.
And, as for the turmoil in the banking sector, we’re possibly over the hump but it would be foolish to count on it.
Look, first, at what could conveniently be called the US subprime crisis.
IMF calculates banks have recognized roughly two-thirds of their expected losses from US residential mortgage lending, and a somewhat smaller portion of expected losses from commercial real estate and loans for leveraged buyouts.
Getting this far has been extremely painful. It has forced several financial firms to the brink. But the US Federal Reserve Board successfully stepped in to prevent a catastrophe, in the process throwing its protective mantle around pretty much the whole investment banking industry.
What’s more, banks themselves are coming to terms with their problems. The write-downs haven’t come as fast as a purist would have liked. But they have come a lot faster than in, say, Japan in the 1990s. And banks have also started to repair their tattered balance sheets, most recently Washington Mutual Inc. for $7 billion (Rs28,000 crore).
So the subprime crisis is probably about half-way over. But this chapter won’t be closed until dodgy assets start trading smoothly—and that’s not yet happening. Wall Street is no longer manufacturing new supplies of trashy paper; but the old inventory is still semi-stuck. Even headline-grabbing deals such as Citigroup Inc.’s proposed sale of $12 billion in leveraged loans aren’t quite what they seem. In a round-robin deal, the bank is set to lend the buyers three-fourths of the cash they need to buy the assets.
Although some assets now appear cheap, nobody wants to catch a falling knife. Morgan Stanley’s John Mack said he was keeping his powder dry. Another Wall Street titan was even blunter in private: he is still looking to cut leverage.
No wonder banks and brokers seem to be falling over themselves to tap central bank lending facilities on both sides of the Atlantic and that the spread between interbank interest rates and base rates is still exceptionally high.
Now look at the real economy. Most observers think the US is already in a recession and Europe is slowing rapidly. But financial pain from higher unemployment and an increase in bankruptcies has yet to be felt. Much of the focus point, again, will be housing—albeit no longer loans that started out as subprime.
House prices have already fallen sharply in the US and started to drop in other markets such as the UK. But they could drop a lot more. The sharp rise in defaults in the last few months presages a 14% further decline of average house prices, according a Goldman Sachs analysis of historical patterns.
Further falls in house prices will cause consumers to tighten their belts, creating a further drag on the economy. That, in turn, will provoke a new rash of loan losses for banks. And, they may not be well placed to take more pain.
Would the losses be enough to provoke a new chapter in the banking crisis?
The central bankers converging on Washington this weekend will certainly hope not. But they should also realize that they, especially the Fed, have exhausted a lot of their firepower by slashing rates and spraying liquidity into the markets inrecent months.
The authorities should use the current breathing space to redouble pressure on banks to raise more capital. That way,if another tsunami hits, there’s less risk of everybody being swept away.
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First Published: Fri, Apr 11 2008. 11 23 PM IST
More Topics: IMF | Banks | Capital | Money Matters | Global Markets |