Today, the US Federal Reserve, the European Central Bank, the Bank of England, the Bank of Canada, the Swedish Riksbank, the National Bank of Switzerland and the monetary authority of the United Arab Emirates all cut their official policy rates by 50 basis points. The People’s Bank of China cut its one-year benchmark lending and deposit rates by 27 basis points. I had been hoping for (and had called for) a coordinated rate cut, but had not expected anything of this scope. It is timely, necessary and most welcome. The fact that the Chinese monetary authority and a key GCC monetary authority participated is of great symbolic significance and marks the accelerating shift of global financial and economic clout to the Far East and the Middle East. But the contribution of the rate cuts to ending the confidence crisis is dwarfed by the actions that have been taken or will soon be taken, by the fiscal authorities in the North Atlantic area.
As a cure for the lack of trust and confidence and for the fear verging on panic that have pervaded financial markets for the past week, the rate cuts contribute no more than good mood music. Under current disorderly financial market conditions, these reductions in risk-free short nominal interest rates will have but a limited effect on the marginal cost and the availability of funds to banks and other highly leveraged institutions. And the rate cuts don’t address the causes of the disorderly market conditions themselves. With the usual long, variable and uncertain lags, these rate cuts will also bolster future demand, output and employment, which is desirable given the unexpected further worsening of the outlook for the real economy during the past month.
In addition to the coordinated rate cuts, there was some more monetary policy action. In the UK, the Bank of England will continue to repo on a large scale at 3 months maturity for sterling liquidity and at one-week maturity for US dollar liquidity. By its still exceedingly exigent standards the Bank of England will repo against an unusually wide range of collateral (still just triple-A rated stuff, however).
But the really important actions have been those directly addressing the capital needs and the funding and market illiquidity faced by the banking sector. The British government has, belatedly, done the right thing.
- The guarantee on new credit to banks is likely to be of significant help in restoring the banks’ access to external funding. It quite cleverly minimizes tax payer exposure by not including the outstanding stock of bank debt in the guarantee; only new borrowing by banks is covered. The £250bn budgeted for this may not be enough. The facility should be uncapped and open-ended. The fee charged for the guarantee will determine to what extent the tax payer is subsidising the shareholders and creditors of the bank by offering this guarantee. Technically, the guarantee for deposits has not been extended beyond £50,000, but it is clear that, for better or worse, the Treasury now offers a de facto unlimited guarantee on all bank deposits – retail and wholesale. The inexplicable decision of the Chancellor to bail out the greedy and ignorant who put their money in Icesave accounts because of the high interest rate (“Daddy, why does your account earn more than the risk-free rate of interest?” “Because Daddy is a financial genius, my child”).
- The capital injection into the banking system (£25 bn now with £25 bn more held in reserve) addresses the insolvency risk of UK banks directly. Fortunately, all banks that matter appear to have signed up. As the scheme is voluntary, this was not a necessary outcome. Fear of being stigmatised as an outfit lacking faith in its own capacity to survive could have stopped some banks from participating. As a precaution against this, participation should have been mandatory. The government gets preference shares or permanent income bearing shares (PIBS, that is, fixed interest rate securities with an infinite maturity). At the very least, the preference shares or PIBS should be convertible into ordinary shares or come with a warrant offering the same upside and control rights. In my view the state should get a seat on the board of every participating bank, to add voice to the threat of exit as an instrument of control.
- The SLS is to be increased to £200 bn, that is, doubled in size. It still applies only to securities backed by assets originated no later than December 31, 2007, which is unfortunate. It also is the exact opposite design feature of the Treasury’s new funding guarantee, which applies only to new bank borrowing. We accept only old junky assets, but we guarantee only new unsecured borrowing. There may be a logic there somewhere, but I cannot find it.
What else can be done?
- As regards the monetary authorities, further interest rate cuts may be required, although for the moment it is better to keep one’s power dry. The Fed, with a mere 150 basis points to go until it hits the zero lower bound on nominal interest rates, should not waste any rate cuts on wildly irrational markets.
- The Bank of England and the ECB should follow the example of the Fed and engage in unsecured lending to non-financial corporates. The Fed does this by buying commercial paper.
- In addition, the Bank of England should lend unsecured to banks and building societies, to try and get the (unsecured) interbank market going again. From the perspective of a traditional central bank, unsecured lending is akin to committing an unnatural act, but these are extraordinary times. The Treasury should of course automatically indemnify the Bank of England for any losses incurred in its unsecured (and secured) lending operations.
- The amount of money provided for recapitalising the UK banks seems small (even if the full £50 bn is paid out) compared to the likely future losses the banks will incur/recognise and given the need for significantly higher capital ratios and lower leverage ratios in the future. The amount ultimately needed could easily be twice or even three times the amount currently on offer.
- Capital adequacy should not be judged from any capital ratios that involve risk-weighted assets, unless the risk weights can be determined by the Regulator alone, on the basis of independently audited information. An example of a defective capital ratio is the Tier one capital ratio – the ratio of a bank’s Tier one or core equity capital to its risk-weighted assets. Tier one capital consists of shareholders’ equity, preferred stock that is irredeemable and non-cumulative and retained earnings. Risk-weighted assets are the total value of all assets held by the bank, weighted for credit (default) risk according to some formula, set accoring to guidelines from the BIS. Under Basel II (which is now in effect) the risk weightings are partly determined by credit ratings assigned by the Big Three credit rating agencies, and partly by banks’ internal models. Both the credit ratings and the internal models have strong procyclical effects. The internal risk models of banks are worse than useless for regulatory purposes not just because they are procyclical. Even if they were used honestly by the banks that pay for their construction and maintenance, they would be useless because the correlations that drive them change dramatically and unpredictably during crises. They are worse than useless because they represent private knowledge of the bank and therefore can be used as instruments of deception by the banks in their interactions with the regulator. Because of this I take little or no comfort from high capital ratios when the assets are risk-weighted. Simple unadjusted leverage ratios are likely to be much more informative, because in practice higher leverage goes together with increased mismatch and risk. Therefore, as regards capital ratios, Basel II represents technical regress relative to Basel I. The government should specify target maximum leverage ratios for all highly leveraged systemically important institutions and inject capital into them until the actual leverage ratio is at or below the target ceiling. Alternatively, it could mandate conversions of existing debt into equity until the leverage ratio is below the target ceiling. Participation in these deleveraging exercises should be mandatory.
- If the government’s capital injection is viewed as an emergency intervention only, there should be no dividend payments, share repurchases or other economically equivalent financial manoeuvres benefiting any shareholders other than the government until the government equity has been repaid in full, at a time of the government’s choosing.
- A UK version of the US TARP, or toxic asset fund, where illiquid complex securities are bought outright with public money would be helpful. It would take some of the toxic waste off the balance sheets of the banks and allow the remainder to be properly marked to market, using the prices paid by the TARP. This would remove the remaining uncertainty about who holds these toxic assets.
- There should be no weakening of mark-to-market accounting and reporting. The SEC got that wrong, as it did everything else it touched. While the practice of marking to market is procyclical, giving management a blanket authority to make up numbers would be a cure that is worse than the condition. The regulatory authorities can suspend the regulatory capital ratios, liquidity ratios or leverage ratios if disorderly and illiquid markets threaten to make mark-to-market accounting and reporting pro-cyclical. The transparency and information provided even by illiquid markets cannot be missed.