[R-G] Lack of Trust Lurks at the Heart of Banking Trouble

[Yoshie Furuhashi]

<http://www.ft.com/cms/s/0/d72e4baa-303b-11dd-86cc-000077b07658.html>
Lack of trust lurks at the heart of banking trouble

By Tony Jackson

Published: June 2 2008 03:00 | Last updated: June 2 2008 03:00

Investors are getting twitchy about the banks again. Several UK bank
stocks, for instance, are at multi-year lows. But in a wider and more
global sense, the twitchiness never really went away.

The gap between official policy rates and those at which banks lend to
each other has been widening for several months. At the start of the
year, it had subsided almost to normal levels. Now, although a little
off the peak, it is still a good deal wider than when the crisis first
struck.

There has been nothing quite like this before. A crisis of confidence
in the banking system is scarcely new. But on this measure it has
never been so acute, nor has it lasted so long.

Four reasons are commonly adduced. First, the banks do not trust each
other, so will not lend. Second, they do not trust themselves either,
so are hoarding their liquidity against future emergencies. Third,
outside lenders - the money market funds especially - are no longer
buying bank paper as they used to. And fourth, the banks are allegedly
playing games with Libor, the interbank rate used in the US and UK.

Let us get the last two out of the way first. The money market funds
are certainly lending a much smaller proportion of their money to the
banks. But in absolute terms, the amount of bank paper they hold has
risen. In the US, the latest figure I have seen puts the year-on-year
increase at some $175bn. International money market funds, according
to their trade body, the IIMFA, have increased their holdings by close
to $100bn.

The snag is that this nowhere near covers the explosion in the banks'
assets caused by dodgy loans and securities stranded on their balance
sheets. Hence the hundreds of billions lent by central banks lately in
an attempt to meet the shortfall.

The timing is important here. In response to the original funding gap,
the cost of interbank borrowing went up. But when the central banks
stepped in, the cost did not go down again. It seems logical to infer
that the underlying situation has got worse in the meantime.

As for the reliability of Libor, this is for our purposes a red
herring. It may be that banks are understating their cost of
borrowing. If so, the real situation is worse again. But it is worth
noting that Euribor, the eurozone equivalent of Libor, is calculated
in a different manner, and yet has been behaving lately in a very
similar way.

That leaves us with our two opening hypotheses - lack of trust between
and within the banks themselves. Again, there are two possible reasons
for this.

The more benign one has to do with the real economy. Loan default
rates are still low, but in any lending cycle - let alone the last one
- are bound to turn up eventually. In some economies this applies
particularly to housing - the immediate cause of the weakness in UK
bank stocks, along with impending cash calls designed to rebuild
balance sheets.

The more worrying possibility, because less quantifiable, is that the
banks have not yet disclosed or recognised all the toxic stuff on
their books. In the case of the investment banks this seems unlikely,
because they are obliged by the nature of their operations to mark to
market. But in the case of some commercial banks, in Europe and the UK
especially, the level of writedowns still seems perplexingly low.

One subsidiary factor I have heard suggested is that interbank lending
used to be in effect free money - a very low return, but riskless. Now
that lending is risky, it is a headache the average bank treasurer
does not need, whatever the return. Better to pull the horns in and
stick to internal financing.

That is no doubt true, but only restates the essential problem in
another way. So where does this leave us?

Professor Richard Portes of the London Business School is cautiously
optimistic. Granted, the interbank market has never behaved like this
before, he says.

But the market has developed immensely in the past couple of decades.
Cross-border exposures, for instance, have been rising by maybe 15-20
per cent a year.

More important, measures of volatility and risk aversion - in interest
rates, foreign exchange and so forth - may have spiked lately, but no
more than on half a dozen occasions in the past 15 years. Each crisis
in the financial markets, says Prof Portes, takes a different form. So
it is this time. But it will wear off like the others.

A comforting thought, at least in the long run. But in the short term,
recall that while some were claiming recently that the crisis was
over, this particular warning light was still flashing.

The bankers themselves have been worried all along. And after all,
they ought to know.

tony.jackson at ft.com

-- 
Yoshie
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