Banking crisis prolonged by spreading the pain

Banking crisis prolonged by spreading the pain
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First Published: Fri, Apr 25 2008. 10 28 PM IST
Updated: Fri, Apr 25 2008. 10 28 PM IST
As with most policies adopted amid the whirlwind of a crisis, the Bank of England’s offer earlier this week to swap government bonds for mortgage securities to kick-start bank lending has both pros and cons.
The good news is that the UK banking system will probably avoid a systemic collapse. The bad news is that making the swap facility available for three years implies the Bank of England thinks the credit crisis has a long way to run.
The unspoken issue is that the swap may represent another step towards the socialization of risk in global markets.
Since the subprime mortgage crisis erupted last year, central banks and governments have cut official interest rates, pumped huge doses of liquidity into financial markets and diluted the quality of collateral that lenders can use to support central bank borrowing. Capital requirements at government-chartered mortgage lenders have been eased. Banks have been rescued with government funds; one was nationalized.
Governments and central banks account for 75% of the net increase in bank lending since July, says Bob McKee, London-based chief economist at financial consulting firm Independent Strategy. In the US, for instance, were it not for the Federal Reserve’s provision of credit, and funding to banks from government-affiliated mortgage agencies, US bank lending would have contracted during the past eight months.
Socialized credit delays the day of reckoning and distorts asset values. When it is withdrawn, bank lending will shrink. That will hurt the economy and many risk assets.
“Capitalism knows no other way to price capital except by measuring and assuming risk,” McKee says. “If the state assumes the risk, capitalism has no other yardstick by which to price investment.”
Japan represents the poster child of a country that tried to live off socialized credit after its equity bubble burst in the early 1990s. It wasted huge amounts of government resources in a failed attempt to buoy domestic demand. Companies that were effectively bankrupt were kept alive by banks that refused to cleanse their balance sheets by writing off bad debts.
That allowed these corporate “zombies” to continue to function, draining business and resources away from more efficient companies. Japan suffered a decade of deflation.
Countries confronted with a banking crisis have broadly two options. “One is accommodating, involving measures such as liberal liquidity support to banks with cash flow difficulties,” and guarantees to depositors and creditors of financial institutions, wrote World Bank economists Patrick Honohan and Daniela Klingebiel in a 2002 discussion paper.
They also included debtor support programmes, and regulators tolerating the violation of solvency and minimum capitalization rules.
The second approach involves sticking to the rules, mandating that banks meet standard capitalization measures, or be penalized by regulators.
Based on an analysis of 40 crises since the late 1970s, Honohan, now a finance professor at Trinity College in Dublin, and Klingebiel found no evidence that the accommodating policies reduced the fiscal costs of a crisis, but rather increased them. Such costs would have averaged about 1% of gross domestic product if the countries in the study hadn’t pursued the permissive alternative, the economists said. That is a little more than one-10th of the sums spent.
In the current crisis, the UK isn’t the only country to change the rules. The Federal Reserve last month put in place a $200 billion (about Rs8 trillion) swap and agreed to accept mortgage and other securities of questionable quality as collateral to back a $29 billion loan that paved the way for JPMorgan Chase and Co. to acquire Bear Stearns Cos Inc.
On 19 March, Fannie Mae and Freddie Mac, which own or guarantee about 45% of the $11.5 trillion US home-loan market, agreed to expand their purchases of US mortgages and related securities after the Bush administration reduced the amount of capital the companies are required to hold as a cushion against losses.
Meanwhile, lending to member institutions by the Federal Home Loan Bank (FHLBank) system last year surged 37% to $875 billion, compared with a 3.4% increase in 2006. The government on 24 March doubled the ceiling on FHLBank investments to six times capital for two years.
“By injecting so much new money into the banks, FHLBank could be considered as ensuring the orderly functioning of markets,” McKee says. “But the reality is that FHLBank is bailing out financial institutions that had foolishly destroyed their own balance sheets.”
Britain nationalized mortgage lender Northern Rock Plc., while Germany has bailed out at least five banks, three of them with taxpayer funds. The Fed is counting on its Bear Stearns bonds to cover the $29 billion it gave JPMorgan. Similarly, the UK treasury aims to at least break even by the time it sells its Northern Rock stake.
Still, short-term pain relief is just that. The systemic scepticism remain.
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First Published: Fri, Apr 25 2008. 10 28 PM IST