Friday, October 3, 2008
The need to keep an eye on liquidity and its movement - FT, Paul Davies
Securitization, shadow-banks, Credit derivatives free banks from capiatal constraints and allow them to reuse capital to flow faster among parties. These financial accelators not only increased the capital market liquidity, but also spun the credit crisis out of control... The fallout from September's financial turmoil has put banks in such a funk it appears they are no longer talking to each other. Tensions in money markets are so high we have witnessed the extraordinary spectacle of central banks not only providing liquidity but in effect becoming the market. So while the European Central Bank, for example, has made huge injections of emergency liquidity, it has taken in even larger amounts in record overnight deposits at low, penalty interest rates. It is a useful reminder that the concept of "liquidity" does not refer simply to the volume of money available, but also the way it moves, how freely and quickly it can flow between parties. For many this is a statement of the obvious. Less obvious, perhaps, is the corollary: that the greater the freedom and speed with which money moves, the greater its availability - and hence the greater seems its volume. This second point is crucial to understanding the growth of the credit bubble and its subsequent collapse and is summed up in the pithy, rueful words I have heard in some form from a number of senior bankers: "What we thought was a wall of liquidity turned out to be a wall of leverage." The point also has implications for the lessons that both financial regulators and central bank policymakers might take from the current mess. The most important effect of the credit innovations that contributed to the bubble was their impact on the velocity of money when used as capital. In monetarist terms, velocity refers to how often each unit of money is reused, or recycled. For banks, the great leap forward with securitisation - the practice of turning individual loans into saleable securities - was the way it was deemed to reduce, restructure and redistribute credit risk. This freed capital to be used again (and again) to support new lending - and so increased its velocity. However, very smart people who were paid to make capital make more money found a way to increase that velocity further: the "shadow banks". This phrase describes the off-balance-sheet structured investment vehicles and conduits that played a major role in the later stages of the credit bubble. These have been destroyed in the bubble's collapse. The last surviving independent SIV, Sigma Finance, closed this week after banks pulled the plug on its life-support finance. Such vehicles were pure leverage. They were ultimately supported by liquidity guarantees from banks. As long as these guarantees remained only an unfunded pledge, they drew no capital charge. This allowed banks to create even more credit per unit of capital used. (SIVs, unlike conduits, did have external capital providers, but at the point of collapse the banks more often than not bailed them out, in effect taking on the capital risks.) The problem for regulators and central bankers here was that "shadow banks" were not very transparent. Banks were very unspecific in their reporting of guarantees. It was not even obvious that the velocity of capital had been accelerated - except perhaps in asset value inflation. But there was a further spur to velocity. This spur was even more lacking in transparency and may have had an even greater effect: credit derivatives. These are an incredibly powerful accelerant because they allow banks to recycle and reuse capital without even having to fund the extra leverage. David Roche of Independent Strategy, a regular on these pages, argues strongly in his book New Monetarism the importance of these innovations. They drove the expansion of liquidity and the loss of control over credit creation experienced by central banks. In the clamour for a regulatory crackdown on banking and finance, it is the lack of transparency round the use of credit derivatives that demands most attention - including the total return swaps that provide hedge fund leverage and banks' extension of liquidity guarantees. Financial regulators and central banks must co-operate to regain control over liquidity in both its size and its movement. This, more than anything else, is why we need vastly improved awareness, monitoring and control of derivatives.