Bankruptcy

This is a Financial Crisis like Any Other ? Treat it Like One

By Christian E. Weller

I wanted to thank Bob Lawless, Elizabeth Warren and Credit Slips to invite me back as guest blogger. It seems an appropriate time to discuss topics in two of my areas of expertise -- financial crises and retirement income security -- as they are directly related to the current financial turmoil.

The markets are crashing. This is a standard financial crisis, as many other countries experienced over the past twenty or so years. In a crisis four risks materialize: default risk, maturity risk, interest rate risk, and exchange rate risk. We are spared from the last one since the dollar dropped well before this crisis. The problem is that we are not adequately addressing the remaining risks.

Default risk is always part of finance, but it spikes in a crisis. Borrowers cannot pay back their loans and bad loans accumulate on the balance sheets of banks, taking down financial institutions. The bailout was intended to solve this problem. But, the $700 billion Wall Street rescue only cures the symptoms, not the disease. It does not make it easier for homeowners to stay in their homes. To do that, we would need additional steps, such as bankruptcy reform, easier workout solutions for struggling homeowners to refinance their loans, and a second economic stimulus to boost household incomes.

Maturity risk exists because banks are supposed to bridge the inherent maturity mismatch between short-term deposits and long-term loans. But in a crisis this function is broken because banks are not sure that they will have enough short-term deposits to finance long-term commitments. Thus, maturity risk can bring down entire economies. When short-term capital, so-called "hot money", leaves economies, credit markets cramp up because banks run out of cash.

We now see depositors and other lenders to banks completely withdraw their funds or lend only on a short-term basis. Banks don?t know if they will have enough cash to meet all of the demands and thus stop making longer-term loans or even recall loans, e.g. by reducing credit lines.

The Fed's policies are intended to fill this gap. They are supposed to play the role of depositors, when depositors put their money under their mattresses rather than in a bank. Public pronouncements and FDIC insurance increases are meant to do the same.

So, why is this not working? There could be several explanations. First, the gap may be too big for the Fed to fill. Second, there is a reputation problem. Banks that borrow from the Fed may be seen as weaker than other banks and thus may precipitate a bank run.

What can be done? The federal government could step in, take equity stakes in some banks, and tell them where to lend. In essence, we may need a federal development bank that would extend credit for worthwhile projects. The treasury and other governments are already discussing taking equity stakes in financial institutions. Now, the government needs to think how it can act like a banker not just like a lender of last resort.

Even if banks have all the money that they need to lend for longer-term projects, there is still interest rate risk. The interest rate on a loan is fixed for long time. A bank, though, finances this loan out of revolving deposits with shorter maturities. The interest rates on these can fluctuate wildly. Right now, all interest rates are low. If banks think that they are too low, they may want to wait to lock in higher long-term interest rates. More importantly, banks may be worried that short-term interest rates could go up again.

If raising interest rates at this point seems silly, remember that this is what typically happens in a crisis. Central banks raise rates to prevent capital from fleeing a country. The Fed and other central banks are doing the right thing by coordinating their interest rates to avoid interest rate competition, what is commonly referred to as a ?beggar-thy-neighbor? policy approach. The G-7 meeting in Washington, DC on October 10 reaffirmed the willingness of policymakers to solve the crisis, but they missed an opportunity to state that they will regularly consult and coordinate their actions in this crisis until there is a resolution. Such a desperately needed statement would reassure market participants that there won?t be harmful of policy competition and that policymakers in different countries won?t work at cross-purposes with each other.

Full post as published by Credit Slips on October 11, 2008 (boomark / email).