Five years ago banks stop lending to each other... they still don't

In his Guardian column, Larry Elliott reviewed the unraveling of the financial system and the interbank lending market at the beginning of our current financial crisis.

This review is timely as the still frozen interbank lending market confirms that all of the policy responses adopted since the beginning of the financial crisis have not fixed the underlying problem.

The summer of 2007 was a run-of-the-mill affair.... 

Then, on 9 August, came reports that central banks had been active in the markets. The Guardian said the action involved pumping billions of pounds into the financial system to calm nerves amid fears of a credit crunch. 

The trigger for the panic was the decision by BNP Paribas to block withdrawals from three hedge funds because of what it called a complete evaporation of liquidity. ... 

Actually, BNP Paribas said it could not value the subprime mortgaged-backed securities in the three funds and that there was inadequate liquidity to get a reliable price from the market.

Five years on, the global economy has yet to recover from the deep trauma caused by the hubris of the bankers. 

Back then, though, there were few who imagined that 9 August 2007 would prove to be such a milestone in financial history....

A milestone that is so carefully hidden that two Yale professors were left pondering what happened in August 2007 that caused the financial markets to freeze [it is a testament to the non-existence of even minimal academic standards at the leading economic and finance journals that their paper pondering the August mystery was published given that Mr. Elliott wrote about it at the time].

Stripped of the jargon, it is now quite easy to see what happened. Banks were taking large gambles with precious little capital in reserve if the bets went wrong. ... 

In August 2007, the air started to escape from this gigantic bubble. It happened in three stages. The financial sector was the first to feel the impact, because while it was evident that almost every bank had been up to its eyeballs in investments linked to the American housing market, nobody knew for sure just how much money each institution stood to lose. The financial system grinds to a halt if banks refuse to lend to each other, as they did in August 2007....

Please re-read the highlighted text as Mr. Elliott nicely summarizes why banks stopped lending to each other:  they couldn't tell who was solvent and who was not.

The inability to assess how much each bank stood to lose is the direct result of opacity.  In this case, it is opacity into each bank's current global asset, liability and off-balance sheet exposure details.  With these details, banks could independently assess each bank's losses.

Governments arrested the slide into a 1930s-style slump by concerted and co-ordinated action, but wrecked their own finances in the process. Bailing out the banks was expensive, particularly since much lower levels of output reduced tax revenues....

Bailing out the banks was expensive and unnecessary.

In a modern financial system, banks are designed to be able to continue to operate and support the real economy even if they have negative book capital levels.  The reason for this is the existence of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers are the banks' silent equity partner when banks have negative book capital levels.

Since banks don't need to be bailed out with direct investments by the governments, the governments are freed up to use the funds to promote economic growth.

Central banks tried to help out by making credit cheap and plentiful. They cut interest rates and used unconventional methods – such as buying bonds in exchange for cash – to boost the money supply. The hope was this would stimulate a private sector recovery and so provide a breathing space in which governments could repair their finances.

The attempt to solve a crisis caused by credit with even more credit has, predictably enough, proved a failure....

As your humble blogger has documented, not only was the failure of central bank policies predictable, but the wanton destruction caused by these policies was also predictable.

For example, these policies triggered the pension fund/real economy death spiral.  With interest rates artificially depressed, pension funds are not able to generate a return on their investments.  As a result, companies have to make up the pension fund earnings shortfall by using money that would have been invested to grow the economy.  With a slowdown in the real economy, pension fund earnings shortfall get worse and this requires even more money being diverted from growing the real economy.