Neither the recent massive money market injections, the coordinated lowering of interest rates nor the use of public funds to recapitalise banks have done much to restart interbank lending. This action did not solve the underlying problem preventing interbank lending: extreme information asymmetry.
The increasing spreads and shortening maturities in the interbank market reflected the banks’ increasing uncertainty about the quality of their counterparties. In turn, this adversely affected asset values, further increasing uncertainty.
Capital injections or cheaper central bank liquidity does little to address banks’ fears about large loan losses, since neither action reduces the amount of bad assets. It certainly does not show who holds these assets. Hence, such actions do not encourage interbank lending.
Indeed, even a completely nationalised bank, such as Fortis in the Netherlands, had almost no access to the interbank market. If this continues, the government will end up owning the entire banking system. Surely that will start interbank lending, but at a huge cost.
The fear about counterparty risk became extreme. The spreads between secured and unsecured interbank lending between leading banks indicated last week that one in 20 of the big banks was expected to fail.
Resorting to desperate measures, the European Union heads of state agreed as part of their programme to guarantee interbank lending, leading spreads to reduce. After all, with guarantees, information about counterparty quality is not needed.
This indicates that if it were possible for banks to better identify which banks are reliable, interbank lending would pick up. Unfortunately, in the absence of reliable market prices, banks do not know how to value their own assets and liabilities, not to mention understanding what is behind the balance sheets of their counterparts.
The market is thus unable to identify the institutions that hold excessive amounts of toxic assets and which do not. Making things worse, by availing themselves of government largess, the banks signal that their toxicity may be excessive, whether warranted or not.
Banks do not need complete information about the counterparties to lend. In normal times, banks rely on several mechanisms for providing the necessary information, such as accounting disclosures and credit rating agencies. In the current environment, accounting disclosures on complicated structured products are insufficient and the rating agencies are no longer trusted.
Therefore, breaking the information asymmetry needs stronger measures. While difficult, painful and undoubtedly resisted by some of the banks, one alternative template exists: Information exchange. Before takeovers and mergers, companies pore over each others’ balance sheets. Without this due diligence, the information asymmetry is too large a risk for a merger.
A similar process of information exchange could help break the information asymmetry currently preventing interbank lending. If the central banks and governments pressured the largest banks to open their books to their counterparts, in a manner similar to bank mergers, banks would be able to confidently lend to each other, or refuse lending with good reason.
It is quite likely that banks would be able to offset many of their toxic assets, so long as they had the required information. The government should be ready to take over banks denied access to the interbank market even after such disclosures. It would eventually have had to do that anyway.
While such disclosure may be resisted by banks, the costs of disclosing possibly superior proprietary pricing information are exceeded by the public private benefits of information revelation. Disclosure about the most contested parts of the banking book would establish the necessary trust for the money market to restart, so long as this process was coordinated between the major banks.
The scheme should therefore be initiated by the major banks, and subsequently expanded to include smaller institutions. The six largest cooperative banks in the European monetary union area last week announced to voluntary start such a scheme. Spreads are already coming down.
By following this approach, banks obtain the necessary confidence for unsecured interbank lending, without needing the massive resources currently on offer from the government. This would be cheaper for the taxpayer, less intrusive for the banks and more effective than the alternatives.
http://blogs.ft.com/wolfforum/2008/11/money-market-on-strike/
