Wednesday, November 30, 2011

Bank regulators trigger credit crunch that central banks to try to head off

In a classic case of regulators acting as a source of financial instability, the Eurozone bank regulators decided that Eurozone banks should prove their solvency by achieving a 9% Tier 1 ratio.

Eurozone banks, seeing that any common equity offering would be highly dilutive, responded by shedding assets (the denominator in the ratio).  Assets shed included sovereign debt from countries experience financial difficulties and loans.

Most of this has been achieved by allowing the assets to mature and not rolling them over.  After all, when everyone is a seller, the question is who is the buyer.  The rapid increase in the interest rate that troubled sovereigns have to pay to issue debt is a sign of how few buyers there are.

Another way that banks have reduced their assets is by slowing down the pace at which they originate and book new loans.  Unfortunately, this has a significant impact on the real economy -- namely, a credit crunch.

Oh, by the way, all this activity by the banks does nothing to prove that they are solvent.  The bad assets on the bank's books are still there.

Why?  Since the beginning of the solvency crisis, financial regulators have allowed banks to engage in a wide variety of practices that kept the banks from having to mark down the assets -- examples of these practices include securities being marked to model as well as extend and pretend being applied to loans.

Selling these assets today would cause the bank to incur losses.  These losses would make it harder to achieve the 9% Tier I capital ratio.

In a preverse way, by requiring Eurozone banks to achieve a 9% Tier I capital ratio, regulators have actually made the banks riskier.  The assets that the banks are busily selling, not rolling over will tend to be their better performing assets.

Truly, there is nothing good coming out of the 9% Tier I capital ratio policy.

As the Guardian reports, the global central banks have responded to try to head off the problems caused by this policy.

Central banks from around the world have announced emergency measures to boost liquidity in the global economy and prevent the financial system from freezing up. 
In a clear sign that policymakers fear the downturn in the eurozone risks spiralling into a fresh credit crunch – where banks stop lending to each other – they announced "co-ordinated central bank action to address pressures in global money markets". 
The Bank of England joined the Federal Reserve, the Bank of Japan, the ECB, the Bank of Canada and the Swiss National Bank in taking the measures ....  cut the price of emergency dollar loans to cash-strapped banks by 0.5 percentage points, and extend the scheme until February 2013. 
They will also establish "temporary bilateral liquidity swap arrangements" between one central bank and another, allowing liquidity to be provided at short notice in any currency "should market conditions so warrant"....
The central bankers fear that if financial institutions rein in credit, it will hit ordinary consumers and businesses, and threaten a double-dip recession in the world economy. 
"The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity," they said in a joint statement. 
Separately, the ECB, which has come under intense pressure in recent weeks over its role in the deteriorating eurozone crisis, said it would now be able to provide liquidity to struggling banks in yen, sterling, Swiss francs and Canadian dollars if necessary. 
Central banks have become increasingly nervous in recent days as declining confidence in the health of the euro, and of many major banks in the single currency zone, has pushed up the cost of funding for banks whose balance sheets have already been ravaged by the credit crunch and the recession. 

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