Thursday, October 02, 2008

Oiling the system

Oiling the system

Sep 28th 2008

It may seem unfair, but a bailout is essential

SUSPICION of banks is a recurrent historical theme, from President Andrew Jackson’s opposition to “money power” in the early 19th century, to the British Labour party’s suspicion of the “bankers’ ramp” that forced it from office in 1931.

So there is a natural temptation to think that the current crisis may be entirely artificial, a device dreamed up by bankers to help them out of a hole. But if there is a conspiracy, it is extremely well organised and extraordinarily risky.

The money markets are a bit like the sewers of the financial system: in normal times, nobody notices them but when they get blocked up, the stench is abominable. And they are severely congested at the moment. The good news is that, unlike last week, it is possible for banks to borrow overnight at a reasonable rate. The bad news is that borrowing at longer rates is either impossible or prohibitively expensive.

Why is this? The problem seems to relate to the money-market fund sector, which suffered an outflow of assets when one of them “broke the buck” (failed to repay clients at face value) last week. Other funds are desperate not to repeat the trick, so are desperately opting for safe assets, which means those offered by the American government.

Consequently, three-month Treasury bills were yielding just 0.43% last week (something like 2% would be more normal). According to Barclays Capital, the cost of long-term financial debt was some 450 basis points (4.5 percentage points) above that of government debt, compared with a normal spread of less than 50 basis points. Shorter term, the gap between three month Libor (the rate at which banks borrow) and that paid by the government is getting wider and wider (see chart).

At that level, it is simply uneconomic for banks to lend money to customers. So they won’t. Banks are getting by on borrowing overnight, but the markets for one and three-month loans have dried up. That explains why central banks have been forced to offer billions of dollars at those maturities.

This cannot last long without causing immense damage. Companies will be unable to raise new money and, more importantly, refinance old loans. Corporate bankruptcies will soar. Consumers will also find it difficult, or expensive, to borrow. The result will be a sharp downturn in demand that will push the economy into a deep recession.

So some kind of bailout deal is necessary. Whether all the details were right is, at the moment, secondary to whether it does the trick. And the trick will be the restoration of confidence in the banking system.

It is, indeed, unfair that banks tend to be rescued when they go wrong whereas coal mines and shoe retailers do not. But banks play a key role in oiling the system; they provide the credit that lets the rest of us do business. They also have innate risk, because they lend more money then they have cash in hand. To put it another way, they borrow short and lend long. This has made them the subject of panics throughout history, and those panics have always led to economic turbulence. The authorities can let them go bust, but the risk is depression. Or they can hold their noses and bail them out.

They have, after all, not got away entirely scot-free. A lot of bonuses in recent years have been paid in the form of restricted stock, and that has fallen sharply in value. Jobs have been lost at Bear Stearns and Lehman Brothers, and more will follow. In future, banks will have to accept a lot more regulation; in particular, higher capital ratios that will restrict the potential for profitability.

And there will be more crises in future. Now that investment banks are part of commercial banks, we have returned to the risks that characterised the system before the Glass-Steagall Act of 1933—specifically, that reckless investment banks can fritter away retail depositors’ money. And what will we have to do if that happens? Bail them out again.

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