Thursday, September 25, 2008
Financial system learns to adapt to cruel necessity
Governmen is resolving short term issues gripped the market. The long term issues remains: the growth of the economy, the reserve currency status of the dollar, the attractiveness of the financial market as a destination for foreign savings.... Who would have ever thought that the most sophisticated financial system in the world - that of the US - would trigger the most dramatic government rescue operation in history? Some may see this as a sad indication of the sharp and rapid deterioration in the standing of the country. More accurately, it speaks to how quickly the cruel realities of an unanticipated deleveraging process can alter the policy and institutional landscape. As is now widely recognised, left to their own devices, US financial markets simply could not accommodate the large and simultaneous shrinkage of multiple balance sheets without major damage to institutions and, critically, the system. Last week, the damage had migrated to the essential component of any financial system - the smooth functioning of cash, collateral and counterparty risk management. You would think all this would be too arcane for the politicians to take notice until it was too late. Yet they did because disruptions affected money market funds and, as such, became a real and present danger to the average American. In these circumstances, the authorities had no option but to act urgently. They did so by coming up with a bold and targeted multifaceted approach. In the process they made two transitions that are key to successful crisis management: most importantly, move away from piecemeal measures and towards a comprehensive and self-reinforcing policy programme; and see internal measures supported by some action by other countries. The proposed package has three elements that will likely be reinforced in coming weeks. First, injecting liquidity and providing insurance to restore some normalcy to money markets; second, and currently subject to intense Congressional debate, using the government's balance sheet to stabilise free-falling asset values, including those that have clearly overshot and will ultimately make money for taxpayers; and third, a counter-cyclical regulatory response that, controversially, stymies short sellers. If implemented fully and reinforced in a timely basis, this policy package will likely succeed in stabilising markets and help jump-start the process of repair. But it will not assist every institution and investment fund. Expect further casualties to be concentrated among smaller banks and some hedge funds. These shorter-term issues are important, but they should not be allowed to divert attention from some longer-term questions that will fundamentally impact the country's growth potential, the reserve currency status of the dollar and the attractiveness of US financial markets as the destination for large foreign savings. Four items are likely to dominate. First, the steps leading to the package, and the package itself, have fundamentally, but not yet coherently, redefined the financial landscape. Second, the banking system is now converging towards a more heavily regulated "utilities model". It will be slimmer, less risky and less profitable. Society can no longer underwrite the risk of a banking system that is seen to privatise the gains and socialise the losses. In the process, the growth potential of the US economy will be negatively impacted. Third, with the disappearance of investment banks, institutional investors must get used to a world with fewer counterparties. Judging from the experience of other countries, this may favour large institutional investors and encourage consolidation, especially among hedge funds. Finally, risk premiums will be re-aligned throughout markets. Most notable, instruments benefiting from government support (such as mortgages) will outperform Treasuries issued to fund the rescue package, and outperform instruments outside the package. These are complex structural changes that the system will only be able to accommodate over time, and not necessarily in an orderly fashion. They reflect the fact that, in responding to crises, policy actions involve both intended and unintended consequences.