Bringing money markets back to life

During the last couple of weeks, governments and economists have become increasingly inclined towards the temporary insurance of a broad set of bank liabilities (including, at least, retail and interbank deposits), a policy option that I already defended in March 2008.1 In this column, I revisit some of the arguments that support the desirability of this emergency measure and its potential to bring money markets back to life.2

The current banking crisis is characterised by two strongly related ingredients: (i) the general concern about the possibility of experiencing a long sequence of bank failures around the globe, and (ii) the collapse of money markets. These ingredients share a common cause, the prior excesses in subprime lending and securitisation. The rise in counterparty risk due to the presence of some unidentified potentially insolvent banks created a severe “lemons problem” that, together with the self-fulfilling power of confidence crises in banking, led to the collapse of money markets. In the absence of active interventions, the normal functioning of money markets will only be restored once the current concern on counterparty risk disappears.

A temporary and aggressive extension of government guarantees on a broad set of bank liabilities could temporarily reverse the connection between the concern about bank failures and the money market collapse. If money markets lose their panic mood and recover their vitality, banks and supervisors may concentrate their efforts on sorting out the mess in banks’ balance sheets without having to worry about the refinancing of the maturing fraction of each bank's debt. Restoring the exchange of funds from agents with financial surpluses to agents with financial deficits would prevent further damage to the capital positions of banks and firms with net refinancing needs, reduce the inefficiencies associated with a severe credit crunch to firms and households, and facilitate a quicker macroeconomic recovery.

Rather than a sign of desperation, a concession to greedy bankers, or a further step in the moral hazard logic, adopting this measure can be an effective way to minimise the losses of the crisis to the society as whole.

Urgency of the situation

As it has been extensively pointed out elsewhere, the roots of the current crisis are at the global and massive spreading of risks associated with a severely inflated US housing market (and its dangerous subprime mortgages) through a complex range of credit default derivatives, securitisation vehicles, and the explicit or implicit credit enhancements provided by the originators.

In the summer of 2007, the news on a first bunch of defaults on these products and their subsequent and radical downgrading created a huge increase in counterparty risk. An immediate implication was the widening of spreads and shrinkage in the volume of transactions on global money markets. After months of speculation on which bank would be the next to fail – either due to the disclosure of subprime-related losses or refinancing problems caused by the lack of confidence of its potential financiers (including the shareholders) – the casualty count is appalling and – worse – there is no evidence that the process is nearing a natural end.3

These months have shown that no government is willing to assume the consequences of ex post denying support to its “systemically important” institutions. There has been ad hoc commitment of public funds or the extension of public guarantees to some bank liabilities. We have seen them offered on a bank-by-bank basis, as in the case of Fortis, and on a more system-wide basis, as in Ireland. Interpreting these measures as acts of desperation and alluding to moral hazard concerns, many authorities were initially reluctant to imitate their presumably more desperate peers. Meanwhile, money markets remained inoperative, the credit crunch became tangible for an increasing number of households and firms, and the worst expectations about the prospects of the economy as a whole gradually unfolded.

Money markets’ failure

Banks are crucial intermediaries in capital markets, facilitating the transfer of funds from many agents with financing capacity to many agents with financial needs. In normal times, access to interbank markets or other money markets allows many banks to lend many more funds than those taken from their depositors, and vice versa. Entire national banking sectors can be net lenders or net borrowers of other banking sectors (or the rest of the world) through capital markets. This creates a complex network of interdependencies, risk-diversification, and systemic risk, but it also contributes to funds flowing from the most abundant sources to the most profitable uses.

In general, the flow of funds between banks and across national banking systems is a natural implication of reasonably integrated national and international financial systems, increases aggregate investment and output, contributes to economic growth, and is welfare-improving. Of course, market failures may also occur (and call for public intervention), as in other markets. The list of candidate market failures in capital markets is long, if only because of the information, incentive, contract-enforceability, and confidence problems to which the trade in “promises to pay” is most vulnerable. Public intervention will typically take the form of regulation, sometimes accompanied by arrangements such as deposit insurance schemes that may involve taxes, subsidies, and transfers.

In the case of subprime-related products, the mispricing associated with the housing market bubble and a clear underestimation of the underlying risks by almost all the involved players (including the regulators), created a terrible misallocation of resources. The US housing market (and, to a lesser extent, other housing markets with booming prices) received excessive credit in the sense that part of the savings directed to that use through markets and banks were, arguably, misallocated. In parallel, however, the same markets and many banks were performing the useful function of applying other funds available across the planet to their most profitable uses.

The prolonged disturbance of money markets is producing a severe form of financial market segmentation. Roughly speaking, banks seem bound to lend at most the funds that they can take as deposits. However, both loans and deposits are, to a large extent, local products, since they are commonly attached to a variety of information-intensive relationships and services that are local in their nature (personal attention, advice, monitoring, and some of the payment services). Hence, forcing banks to restructure their existing costumer bases and to lend and borrow under the new constraint that no net financing can be obtained out of their own local (insured) deposit market can be terribly restrictive.

Neighbouring banks would likely enter wars for deposits in the short run and many of them may be forced to reduce their lending relative to their pre-crisis levels, with no guarantee of other banks replacing them, especially in the short run and in economies with banks that have been structurally receiving net financing from abroad.4 The most immediate manifestation of this misallocation of resources would be the deepening of the credit crunch and an increased fear of macroeconomic depression. Additionally, the process of adjustment would also have a cost in terms of lowered bank profitability, worsened solvency, more bank failures, and more costly rescue packages. The parallel deterioration of government accounts will not help. The vicious circle, unless effectively short-circuited, might lead the global economy into the worst recession in recent history.

Proposed response

It is time to manage the exit from the current crisis in the least socially costly way. Extending a temporary and aggressive guarantee on a broad set of bank liabilities (including, at the very least, retail and wholesale deposits) will bring the corresponding segments of the money market back in operation, not only reviving their usual trade but also absorbing some of the normal trade of the uninsured segments. The key role of money markets in the allocation of funds will be restored, pressures on central banks to act as substitutes for the missing market will vanish, and the possibility of a credit crunch artificially exacerbated by some banks’ refinancing problems will become more remote. The restored money market transactions may become useful sources of information for supervisors to keep track of the institutions they oversee and for central banks to manage liquidity provision and monetary policy actions in a more effective way.

The insurance of bank liabilities should be provided by the governments in charge of supervising each bank (in the European Union, essentially the governments of the “home country” where the bank is domiciled). An exception should be made in the case of banks whose size is excessive relative to the country of reference, where special arrangements based on multilateral cooperation or the involvement of an international organisation to which the role is delegated should be promptly devised.

Government guarantees are not a substitute for supervision but a complement. Free from short-term liquidity pressures, supervisors should focus on banks’ long-term prospects and limit their behaviour or encourage restructuring as needed. Supervisors should continue exerting discipline through the usual means (capital regulation and prompt corrective action) and explore new ones, based on, for example, establishing an upper limit to the total borrowing under coverage and conditions that can increase or decrease it over time. In the spirit of the Basel agreements on capital requirements, the upper limit might be related to the bank’s capital and perhaps also to some objective measure of the risk of each bank’s assets. Supervisors should be granted powers to use the threat of announcing the withdrawal of the guarantees for future borrowings as a means of encouraging banks to undertake controlled asset sales or fresh equity injections, or to move into a gradual use of uninsured borrowing once the crisis is resolved.

The harmonised introduction of the arrangement by a number of important countries (for example, at the level of the whole European Union or a large subset of its members) will definitely facilitate its success in restoring the functioning of international money markets and minimise criticism of its potential to “unlevel the playing field” in international banking. However, if harmonisation is not feasible in a timely manner, countries should proceed with their unilateral adoption. The urgency of the situation and the genuine value-added of the scheme, relative to its potential to cause negative externalities to non-joining neighbours, should outweigh the standard “fair play” arguments. Hopefully, proving the arrangement’s advantages in a few countries will soon cause others to follow suit.

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1 For details, see "The Need for an Emergency Bank Debt Insurance Mechanism", CEPR Policy Insight No. 19, March 2008.
2 Conversations on an earlier version of this proposal with Benjamin Alonso, Max Bruche, Stephen Cecchetti, Darrell Duffie, Abel Elizalde, Anil Kashyap, Luc Laeven, Rafael Repullo, Fernando Restoy, Jean-Charles Rochet, and participants in the 2008 European Summer Symposium in Financial Markets in Gerzensee were especially useful to shape the opinions expressed in this column, of which I am solely responsible.
3 Even in the US, the recently approved Treasury Plan will take time to apply and there are numerous uncertainties on the particular way (price, time, etc.) in which each institution will manage to get rid of its toxic assets. Up to the full execution of the plan, markets may fear that a bank may go under and its creditors may suffer losses.
4 Some reduction in credit relative to pre-crisis levels would be perfectly justified by the new demand conditions of the recession as well as the correction of prior mispricing affecting, essentially, mortgage related credit.