Tuesday, November 8, 2011

Global liquidity drying up could and should have been prevented

Once again, the failure to require financial institutions to disclose their current asset, liability, and off-balance sheet detail is causing liquidity to vanish.

The Wall Street Journal carried a long article that confirms that banks with liquidity are still unwilling to lend to banks without liquidity because they cannot become comfortable with the risk or solvency of the borrowing bank.

Instead, the Eurozone banks with liquidity would rather park their funds at the ECB.
Bank of Canada Governor Mark Carney said Tuesday that global liquidity is about to dry up again as the European banking system deleverages, and warned that the real economy will soon feel the impact. 
"Global liquidity has fluctuated wildly over the past five years and we are on the cusp of another retrenchment,"...
The reason that liquidity has fluctuated wildly is that banks do not trust their counter-parties.  This is a problem that could be addressed.

Regular readers know that the solution is to have each bank disclose its current asset, liability and off-balance sheet exposure detail.  With this data, other banks can assess the risk of insolvency and adjust both the amount and pricing of their exposure accordingly.

As a result, fluctuation in liquidity would be minimized.
Mr. Carney said bold actions by the European Central bank and the €4 trillion ($5.511 trillion) of unencumbered capital at European banks should ensure there is no European equivalent of Lehman Brothers....
As I recall, Lehman Brothers was undone by its exposure to opaque, sub-prime securities.  Is there any reason to believe that a Eurozone bank cannot be undone by its exposure to the combination of these opaque, sub-prime securities still on their books and sovereign debt?
Mr. Carney said European authorities could reduce the spill-over of deleveraging by having their banks meet at least part of the new requirements through private capital, including so-called contingent capital, an idea championed by Canada.  
Mr. Carney said the current situation is "ideally suited" for this instrument as capital is being raised for an "extreme tail event"—losses on highly rated sovereign debt—"the public nature of which would involve no risk of regulatory forbearance." 
The success of contingent capital is directly related to the degree to which banks provide detailed disclosure of their current assets, liabilities and off-balance sheet exposures.

Without this disclosure, investors have no way of assessing the riskiness of the bank and the likelihood that the contingent capital will be converted.

What Mr. Carney appears to suggest is that banks issue contingent capital that only converts if highly rated sovereign debt is written down.  I am not sure that this security would sell today as I am not sure that investors can find a single highly rated sovereign debt that they can be comfortable is unlikely to be written down over the next few years.
Mr. Carney said large, abrupt fluctuations in global liquidity are having a major impact on global financial stability and economic growth. He said the G20's financial reform agenda, when fully implemented, will dampen global private liquidity cycles. 
But the impact of reforms will be weakened if new regulations push activity to the unregulated parts, or the so-called shadow banking system. He said enhanced supervision and regulation of shadow banking will be one of the top priorities for the FSB in coming months....
I look forward to talking with the FSB and seeing them call for making banks disclose their current asset, liability and off-balance sheet exposure details a requirement.
Meanwhile, banks' use of the European Central Bank's deposit facility hit a new high for the year Monday for a third consecutive day, data released by the ECB showed Tuesday. 
Banks parked €298.591 billion at the facility, the ECB said. These data represent the highest level since June 30, 2010, when banks parked €310.43 billion. Friday banks parked €288.429 billion at the ECB's deposit facility. 
The amount of deposits has been elevated, around the €200 billion mark, since late October, indicating that banks prefer to park their money with the ECB instead of lending it to one another. 
Banks are afraid of lending because they don't know the extent of their counterparties' exposure to weak euro-zone sovereign debt. 

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