There is an article in today’s Financial Times, whose title, “Battle-scarred bankers lapse into a hoarding habit,” immediately triggered my interest. The article argues that one of the recent “paradoxes” of the international markets, that recovering stock prices for the leading international banks seem to indicate that the worst of the credit crisis may be over, while very high LIBOR rates seem to indicate the opposite, may be resolved by considering that high LIBOR rates are not a response to credit concerns but rather to old-fashioned hoarding:
Until now, bank analysts have assumed that the high cost of interbank borrowing stemmed from a sense of mutual distrust. This would suggest that, on two occasions in the past eight months, banks have been so nervous of counterparty risk – the danger of one’s trading partners failing to honour their financial commitments – that they did not wish to extend funds to each other.
However, some observers are now thinking that the interbank, or money, market has entered a new, third, phase, one that has less to do with counterparty risk and everything to do with the risk that any institution could face a run on its deposits or other short-term funding. Thus, the problem is not that banks are paranoid about each other, or so the argument goes; instead, banks are paranoid about their own funding state – not least because they have seen what a lack of liquidity did to Bear Stearns.
Large international banks, in other words, are responding to the current financial crisis by hoarding liquidity, as they have always done, at least since the invention of joint-stock banking, I think in the very early 18th century, and even before. We have been reminded very dramatically that banks are clearly vulnerable to liquidity runs. The collapse of my old employer Bear Stearns occurred largely, as far as I can see, because of a very old-fashioned bank run on an institution that was far from bankrupt, or would have been had it not experienced the bank run (i.e. until the forced fire-sale, its assets were worth significantly more than its liabilities). That, plus the experience of Northern Rock and a number of other close calls, has made it imperative for banks that they have sufficient liquidity to meet any potential liquidity run, and for this reason they may simply be unwilling to lend to each other.
The article goes on to point to the policy dilemma.
If this argument is correct, it leaves policymakers such as Mr Trichet facing a huge challenge. In recent weeks, central banks such as the ECB have taken steps designed to reassure the banks that they will be able to get access to liquidity, via special lending facilities, if this is needed. But this may not be enough to break the hoarding habit, some analysts fear, given the stigma that continues to surround these operations.
Instead, many observers now think that the real key to resolving the current tension lies in a corner of the financial system that tends to be ignored and which is outside the hands of policymakers – namely the money market funds, which have amassed some $4,000bn of assets and only make low-risk investments. Until last summer, these money market funds played a crucial role in the interbank market; however, in recent months these funds have effectively gone on strike. That has not merely created a funding shortfall for banks but has also added to the sense of paranoia and thus hoarding.
The possibility and consequences of banks’ hoarding on a massive scale is not something that we normally think about until it happens, but a very strong argument can be made for the case that the root cause of the great stagnation that Japan experienced after the bursting of the bubble in 1990 was the reluctance of Japanese banks to lend. They were selling assets to raise capital and hoarding their resources.
Since the banking system was pretty much the only functioning part of the Japanese financial system (and still is, as far as I can see), the consequences of the financial crisis for the real economy were pretty severe. The refusal to lend and the need to sell assets were, in my opinion, the mechanism by which the financial crisis was transmitted into the real economy.
The US has also had similar, bank-dominated financial crises, but their economic impacts were much more limited. This is because, I would argue, the US has a very diverse and sophisticated financial and capital market that doesn’t leave the financing of the real economy hostage to any one sector.
For example, in the 1970s the US S&L industry was almost wholly bankrupt. That should have put a real constraint on mortgage lending and, via mortgage lending, on the whole housing sector. By “coincidence”, however, that period saw the rapid development of the mortgage-backed securities business, which eventually replaced the role of S&L’s altogether as the source of new mortgages. Similarly the LDC crisis of the 1980s, which left all the major international banks in the US either functionally bankrupt or with seriously depleted capital levels, should have left medium-sized companies and low-rated large companies gasping for capital as these banks struggled to rebuild capital and replenish liquidity (at the time only large, highly-rated companies had access to the bond markets). Given the importance of these companies to the US economy, US GDP growth should have slowed significantly, but the impact of the banking squeeze left barely a blip. Why? Perhaps, again by “coincidence” the junk bond market exploded, fulfilling the role of large banks in providing capital to this sector.
When there are no financing alternatives, what happens to the banking sector in a bank-dominated economy is a very important question, and the causes and consequence of any event that leads to liquidity hoarding should be pretty well monitored and understood. This whole discussion is nominally about foreign banks and the impact of bank hoarding, and not about China, but its relevance to China should be pretty obvious. In China the stock and bond markets are practically non-existent, and financial regulations are so murky and the system so rigid that it is extremely unlikely that any serious alternative to the banks will emerge in the near term (except, intriguingly enough, the informal banking sector, which may turn out to be a real boon in the case of a crisis). Anything that forces the banks – already barely solvent, and almost certain to see NPLs shoot up in a contraction – to confront liquidity issues will directly have a large, and of course self-reinforcing, impact on the real economy.
Meanwhile the stock markets have had another interesting day. I will let my student Shang Ning explain (with some editing on my part):
The SSE Composite opened roughly 1.4% below yesterday’s close, and then declined further during much of the morning to 3523, for a total loss of 1.57%. During the last 30 minutes of the morning session the market started trading up on limited volume and then bounced around to close strongly up at 2.17%, the day’s high.
It seems the rebound was driven at least in part by yesterday’s worst performers. In addition, volume continued to shrink. This is not a market with much conviction.