How G20 can unfreeze credit and cut bailout costs
One of the big historical lessons of this crisis for economic policy is that bringing down the risk-free cost of money – central bank rates or government bond yields – and injecting liquidity into the banking system cannot on their own fix broken credit markets.
Quantitative easing by central banks may help to solve short-term liquidity problems for domestic borrowers and lenders, by going around broken markets during times of extreme financial and economic uncertainty. However, this is no substitute for efforts to restore international credit markets back to health.
Effective policy measures would contain the economic fear and channel private sector incentives – the foundation of free markets – in a way that alters the behaviour of lenders, companies and consumers. The end-game policy strategy cannot be to replace free markets.
So why have traditional monetary stimuli failed to end this crisis? And what should be done next?
The textbook understanding of the relationship between easier central bank money and the supply of liquidity in the broader economy assumes that there is a direct, causal link between banks’ capacity to generate credit and actual lending growth.
However this assumption ignores two important factors – 1) lenders’ incentives and 2) the role of international credit markets, which have come to dwarf traditional bank lending over the past decade.
Credit generation is linked directly to lenders’ perceptions of their profitability, i.e. their risk-adjusted returns. This in turn is determined by borrowers’ financial viability and the value of private sector collateral, provided as insurance for loans, both of which have suffered unprecedented erosion since asset-backed securities (ABS) markets broke down in 2007.
Hence policy efforts focused on the cost of money or lenders’ liquidity have helped to alleviate the effects of the crisis in the financial sector but have so far failed to resolve the causes – fragile investor sentiment and illiquid and dislocated interbank and credit markets. Since these are the forces behind the recessionary disruption of confidence and liquidity in the real economy policy carries a big responsibility.
Over the past several months, liquid and recapitalised banks have continued to shed risk and limit loan growth, despite historically low Libor rates and government bond yields. Even with government efforts to underwrite bank capital and toxic assets, disrupted international investment flows, a global recession and falling credit ratings continue to depress the value of bank assets. Hence lenders and investors have remained exceptionally cautious about the risks that they take on their books.
A glance at G7 monetary statistics reveals the limitations of quantitative easing. In the UK, the voluntary reserves held by banks at the Bank of England surged by 73% year-on-year in February. Yet lending to the household sector contracted by 5.5% and loans to private non-financial corporations rose just 2.1%, the lowest pace in over 6 years. If the uncertainty about credit markets and the economy continues, then corporates and consumers will also adopt lenders’ tendency to build up excessively high levels of precautionary savings.
The risks attached to quantitative easing in an international crisis are not immaterial. Failure to restore the confidence of financial institutions to lend and of companies to invest and hire would lead down the road to a liquidity trap, an environment in which excessive monetary liquidity coincides with a depression in the real economy.
As always, where there are economic risks there are also financial risks, and vice versa. If central banks’ interventions to change private sector financial valuations, for example corporate bond spreads, through asset purchases do not improve the fundamental position of the borrowers, i.e. their ability to raise finance freely in the markets and their economic environment, then investor concerns about a new asset bubble will follow. In a worst case scenario this could lead to a currency crisis as investors flee the domestic market.
A NEW POLICY TOOL NEEDED
The most important lesson from this is that the causal links between depressed lender incentives, disrupted financial liquidity and the international economic turmoil are the forces at the heart of this crisis. An effective policy strategy would go directly to the root of the problem by reducing borrowers’ default risk and so support the regeneration of healthy asset-backed securities markets. This in turn would reduce financial asset volatility and strengthen lenders’ balance sheets. Reduced counterparty credit risk and enhanced market transparency would boost investor confidence and involvement in credit markets and lower private sector borrowing costs.
The way to build this new economic equilibrium is for governments to insure ex ante the “excess” portion of borrowers’ risk associated with the disruption of national and international financial flows. This is about a blanket guarantee scheme which eliminates financial illiquidity risk premia attached by lenders to new private sector loans in cases where markets are malfunctioning.
Central banks can support this credit easing strategy by acting as market makers for structured notes, i.e. bundles of new “insured” corporate and consumer loans. This would ensure liquidity in secondary markets.
Since we first made this argument at the start of 2009, Western governments have announced a constellation of schemes that seek to free up finance in the real economy. The Fed has launched a $1trn Term Asset-Backed Securities Loan Facility (TALF) scheme and the Bank of England has launched credit quantitative easing. There are important steps that will materially improve market conditions, but more is needed.
On a G20 scale, the global crisis requires coordinated policy measures that effectively stimulate balanced international capital flows. These cannot come from stabilizing national banking sectors alone. What are needed are measures to open domestic credit markets to international investors.
The primary benefit of this strategy would be the restoration of market liquidity through incentives that mobilise private sector funds, rather than through increased government borrowing or central banks printing money.
Government guarantees to new loans would have the dual effect of reducing private sector borrowing costs and improving lenders’ expected asset quality and profitability. This would support liquidity in a wide range of correlated markets, from equities to interbank lending.
Since this strategy would also support healthy securitisation activity, it would help to re-open domestic credit markets to the international investor community. This would improve domestic market liquidity and propagate the role of markets rather than individual institutions in the credit cycle.
This would also help to insulate economies from future disruptions in the domestic banking sectors and begin to tackle the problem of banks that are “too big to fail or save”, reducing the cost to the taxpayer.
This strategy focuses on fixing private sector incentives, not on crowding out free markets with public funds. By leaving a manageable portion of risk in the markets, governments can reduce the moral hazard associated with guaranteeing private sector risk and reinforce the incentives for banks to introduce stringent risk monitoring controls, in effect strengthening macro-prudential regulation.
Governments’ claims on borrowers’ collateral in the event of default (and in exchange for a cash payout to the lender) would also serve the purpose to deter asset fire-sales by lenders and hence reduce future risks to market liquidity. Since government insurance conditionality would not prevent irresponsible borrowers from failing, this would also strengthen the structural foundation of the economy by purging private sector balance sheets.
A big advantage to this scheme is that there is no a priori commitment to government borrowing. Reduced systemic risks, a repaired monetary transmission mechanism, and restored investor and producer confidence would instead reduce public sector liabilities.
Another significant benefit of this strategy is that it contains the seeds of its own destruction – once market illiquidity premia have dropped to zero and borrower default rates have stabilized government guarantees will, by default, become redundant. That said, an enhanced policy framework that recognizes both the fundamental (growth and inflation) and the financial (momentum and liquidity) factors in the credit cycle would strengthen confidence in economic policy and act as an “automatic stabiliser” for the economic cycle, reducing the chances that future market corrections will mutate into crises. Continued focus on financial risk premia would send a signal that policy is monitoring and prepared to intervene in both future credit “bubbles” and “anti-bubbles”.
G20 governments have a golden opportunity to address the root cause of the current credit crisis at their London summit. It is time for them to extend asset insurance schemes to new private sector loans to bring the international credit crisis to an end, limit the costs of their bank bailout programmes and reduce the probability and damage associated with future financial crises.