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When you're up to your neck in liquidity...

I note with continuing interest the news that the central banks are continuing to pump money into the markets to "ease liquidity" with a stunning lack of effect.

It occurs to me that they seem to be missing the point.  The issue is not a lack of funds, its a lack of trust.  In essence, we're actually all swimming in a vast pool of liquidity.  The whole banking system, as far as the provision of interbank liquidity is concerned, is to do with trust.  That trust was broken when the sub-prime issue hit the market and everyone realised that no-one had the faintest clue about how much risk they were carrying and how much had been moved elsewhere.  What is also interesting to note is that while everyone agrees that this is a global problem, there seems to be no regulator driven effort to correlate where these risks actually are, how and over what period they are being mitigated.  It looks to the uninitiated like each firm is doing its own thing to fix its own problem, as far as it can - which is entirely reasonable and commercial as far as it goes.  What it does not do, to borrow a phrase from Douglas Adam's famous detective Dirk Gently, is reflect "the interconnectedness of all things".

It seems to me that one of two things is needed.  Either the banks need to collaborate on a more consistent and effective basis or the regulators should get together on a global basis to agree how all the banks should report their risk positions by a given date so that there can be some transparency for us poor consumers that shows that the industry has its head around the issue and is getting things put right.  We need some holistic view of the credit markets that we don't currently appear to have.  Instead, what we get is headline reports of massive right downs and failures without any globalising context.

Looking at the effect to figure out the cause, it seems logical to me that the banks would be falling over themselves to get at government cash, and this has been proven by recent injections all of which were at least five times over-subscribed.  What I fail to understand is why everyone seems so surprised that these injections do not seem to be easing the liquidity crisis.  All this money going in, yet the reaction of the banks is to withdraw mortgage products from the market and make loans more difficult, if not impossible to get.  I can understand to an extent that some of this is "putting things right" by trying to reduce risk at the front end. But surely we can see that the perception in the market is that the banks are getting massive inflows of low cost cash at the same time as they are reducing or even stopping lending.

Being a bear of simple brain, it looks to consumers, who are traditionally not over-enamoured with banks, more likely the banks are taking these funds into their books to bolster their balance sheets and create contingency funds with low cost low risk debt, but then critically not moving these funds on into the market to create more liquidity. Undoubtedly an over-simplification, but I'm a great believer in "Occams Razor" - the simplest explanation has the greatest chance of being the right one.

So, are the central banks pouring good money (our money!) after bad by only addressing one half of the problem.  There should surely be a constraint imposed by the central banks to the provision of this money - that it can only be available to a bank if it demonstrates that it will use the money to ease liquidity i.e. make it available in the system.  Without that constraint, the banks are easing their own liquidity without any noticeable effect on the market as a whole.

I know that this doesn't really get at the root of the problem which is that there needs to be a system in place that globally measures risk as it flows through the system.  Without that, there can be no trust other than limited trust. Quite naturally, and rightly from their shareholder's perspective, the banks will continue to stockpile cash and lend only to the prime market.

While this may seem to be a bit off-topic for me, as my specialisation is withholding tax, there is a link of sorts.  If all the custody banks reclaimed all the tax from foreign governments on behalf of all their clients, instead of the estimated 7% that is currently recovered, the sums generated at over $200 billion a year, would easily offset the entire (estimated) rights offs caused by the sub-prime issue, without the need for any cash injections from the central banks at all.  Just recovering what's already out there and still within statute would net the industry just over $1.2 trillion.  All of which would generate increased fee income for the banks and investment managers and increased returns for investors.  So, the liquidity is out there.  In the same way that the industry needs some centralised way of tracking all this risk so we can (hopefully) see the freight train coming and get out of the way; we could also do with a centralised and automated way to maximise investor value from corporate actions like withholding tax on dividends and fixed income.  SWIFT's promotion of V-STP and its early successful adoption by firms like GlobeTax seem to be moving in the right direction.

And thats just one area of corporate actions processing.  Consider the value of automating other areas of corporate actions.

I also noted in today's press that recent surveys show a major turnaround (and downturn) in predicted spending plans on IT by the financial services sector.  So, again, at balance sheet level, we'll see an overall gain in cash position as the banks cut their spending and increase their intake of funds while optimising the profits by lending only to prime customers.  However, taking into account my comments above, any strategist would and should be advocating that now is the best time to invest, not in IT per se - too much emphasis that software solves all problems - but a renewed expenditure on really extracting value from back office processes like corporate actions.  That means thinking smarter and figuring out what are the smallest things you can do that generate the biggest returns.  I think V-STP has a lot to offer there too, not least because there's no new expenditure, just leveraging what you've already got.

At SIBOS last year the emphasis was on collaboration - and I think thats what we need more of now.  Collaborative efforts engender a perception of working together for the common good.  Being seen to work together and by inference generate results, engenders trust.  And trust is actually what makes the markets work.


Comments: (3)

A Finextra member
A Finextra member 08 April, 2008, 15:00Be the first to give this comment the thumbs up 0 likes As you say - it's all about trust, but we're obviously not exactly up to our necks in trust.
A Finextra member
A Finextra member 09 April, 2008, 06:57Be the first to give this comment the thumbs up 0 likes

Thanks Dean 

I see in this morning's FT that there's a call for a global risk management system and a statement that we won't get out of the crisis til we get one - deja vu?

I also noted something this morning that I missed from yesterday's blog - the effect of commercialism.  With HSBC about to step in to match borrowers existing deals, I guess there may be a slight lessening of the crunch - if "market forces" create a trend of those who are strongest coming back into the market.   Only of any use (i) if other strong commercial players (NOT THE CENTRAL BANKS) come in and start to compete innovatively  as opposed to withdrawing to a corner to play with worry beads and (ii) if the trend either creates a demand or flows over into the interbank market.

So, while we get calls for regulation (self or imposed) to put in place a global risk measurement, management and reporting system, the question is what other black holes are out there that we don't know about? 


A Finextra member
A Finextra member 10 April, 2008, 08:02Be the first to give this comment the thumbs up 0 likes

I read the IIF report this morning and the headlines - banks take the blame for credit crunch.  The IIF report was interesting.  The "coded language" mentions everything they admit they're not very good at - except tracking risk.  Although I guess you might include tracking risk within the context of managing risk, but given what actually happened, I'd doubt it.  

In acknowledging the shortcomings of banks, and agreeing that neither banks nor their investors should be bailed out, its clear that my comments yesterday were very close to the mark.  I noted that one of two things needed to happen.  Either the banks need to put their own houses in order or the regulators will do it for them.  Whats disappointing is that no-one in the chain, whether it be bank, rating agency, accountancy or the banks seems to see the key point.  Each of these actors in the play has only a narrow role to play and generally (and ironically for their own risk mitigation) each stays well within its own silo type rules.

This is the same observation that I made in my book "The New Global Regulatory Landscape" - even regulators can fall into the trap of taking too narrow a view or have a too limited remit.  The result being a system of global regulation e.g. Data Protection, where each regulator's own individual attempts to control and oversee its institutions can have one of three effects on every other regulator's effects in their own country - neutral, constructive or destructive.  Guess which is more common!

While we need risk management and we need to know liquidity levels in each institution and while the firm's credit ratings are a key factor - there are two even more key factors.  We need each firm to consistently track and report where its risk is mitigated and we need either a central banking body (self regulation) or a global regulator to receive those reports and have the responsibility to warn governments and the market when normal operating conditions are breached.

I applaud the IIF's initiative, although I'm usually rather cynical about such things.  And I also agree that self regulation is better than that imposed by others.  It will be interesting to see how quickly the banks continue the good start they've made.

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