Thu, Feb 19, 2009 - Page 9 News List

Banks finding it hard to bite the reform bullet

The financial system cannot right itself. It needs careful intervention to help promote confidence and encourage increased lending

By Raghuram Rajan AND Douglas Diamond

Little political enthusiasm exists for further support to the banking sector. One reason is that banks that received money in the initial rescues do not seem to have increased their lending, without which monetary and fiscal stimulus are unlikely to be effective. For banks to start lending again, even more intervention may be needed.

To see why, we need to understand why banks are still so reluctant. One possibility is that they worry about borrowers’ credit risk, though this would have to be extremely high to justify the complete cessation of long-term lending. A second possibility is that banks worry about having enough resources to meet their own creditors’ demands if they lock up funds in long-term loans. But the many central bank lending facilities that have been opened around the world should assuage these concerns, especially for large and well-capitalized banks.

On the other hand, perhaps the banks’ reluctance to lend reflects a fear of being short of funds if investment opportunities get even better. Citicorp cehief executive officer Vikram Pandit said as much when he indicated that it was cheaper to buy loans on the market than to make them. And buying may get cheaper still!

Consider, for example, the real possibility that a large indebted financial institution faces a run on its deposits, as Lehman Brothers did, and starts dumping loans onto the market. Not only will those loans’ price fall if only a few entities have the spare funds to buy them, but other distressed entities’ scramble to borrow will also make it hard for any institution without funds to obtain them. Anticipating the prospect of such future fire sales — of loans, financial assets or institutions — it is understandable that even strong banks will restrict their lending to very short maturities and their investments to extremely liquid securities.

This may also explain why markets for some assets have dried up. Some distressed banks clearly possess large quantities of mortgage-backed securities and are holding onto them in the hope that their prices will rise in the future, saving them from failure. At the same time, buyers expect even lower prices down the line. While there is a price today that reflects those expectations, it is not a price at which distressed banks want to sell.

As a result, there is an overhang of illiquid financial institutions whose holdings could be unloaded if they run into difficulties. For some, low prices would render them insolvent. For others, low prices would be a tremendous buying opportunity, whose prospective return far exceeds returns from lending today. Political exhortations to lend can have some, albeit limited, impact. Any voluntary resumption of lending will necessitate reducing both fears and potential opportunities.

Here are some ways to reduce the overhang. First, the authorities can offer to buy illiquid assets through auctions and house them in a government entity, much as was envisaged in the US’ original Troubled Asset Relief Program. This can reverse a freeze in the market caused by distressed entities that are unwilling to sell at prevailing market prices.

The fact that the government is willing to buy in the future (and now) should raise prices today, because it reduces the possibility of low prices in a future fire sale. Moreover, once a sufficient number of distressed entities sell their assets, prices will rise simply because there is no longer a potential overhang of future fire sales. Both effects can lead to increased trade in illiquid assets today, and unlock lending, though this outcome may require significant government outlays.

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