What has happened in the last six months?
As discussed in the following article, Banks lend to one another to address imbalances in their loans and deposit bases. However, there is no obligation on a bank with surplus cash to lend to another bank; they just do it because they think they will make a “return by so doing”. One of the factors in that “return” calculation is their assessment of how probable it is that their money will be paid back;
What happened, rather sharply in August 2007, was that banks individually, but all at the same time, suddenly decided that they thought there was a chance they would not get their money back from other banks.
Presumably their thinking was along the lines of “Would I lend to myself – maybe not; if the other banks position is the same or worse than my own I don’t think I should lend to them either.”
This kind of thinking is magnified by the way markets overreact. A couple of banks pulling back from interbank lending sends a signal and then the rest of the market, herd like, follows the signal and stops lending.
What this means is that some banks have a surplus of funds which they choose to sit on. They don’t get such a good a rate of return on them as they used to, but there is no danger of them losing their money. The banks with a shortage of funds are in a much trickier place. They have money market loans falling due for repayment which they do not have any cash to repay with and they cannot borrow from the money markets to repay.
These banks with a shortage of funds have had to go to the central banks (e.g. the Bank of England, the European Central Bank) begging for emergency funding. This puts the central bankers in a very awkward dilemma as illustrated in the diagram below.
Picking up on the example used in “Why and How do Banks Lend to Each Other?” the mortgage bank has lent £0.5M to someone to buy a house repayable in 15 years. The mortgage bank borrowed £0.5M from the money markets on a 3 month term to fund this mortgage. Three months later it has to repay this £0.5M to the money markets. In normal times the market would have re-lent the money to the mortgage bank. But given the general mistrust the money markets say “No we want our £0.5M back please.” Mortgage bank is now stuck and if it cannot repay would be declared insolvent/bankrupt. It appeals to the Bank of England for emergency funding. The Bank of England now has to take a view on whether:
- The market is right, the mortgage bank has got duff loans and so should be punished by bankruptcy; or
- The market is behaving in an overly cautious manner and that the loan book is sound but the mortgage bank is a victim of bad timing/bad luck hence should receive emergency funds.
This is not an easy distinction to make because they are trying to assess the likelihood of mortgage bank getting money in the future; in our example the £0.5m mortgage back in 15 years time.
In general Central Banks have been supportive and have been lending to banks needing funding in the belief that the interbank market has overreacted and that given a bit of time the banks will return to lending to each other. They charge a punitive “rate” of interest for this emergency funding and so banks that have had to get this special help are seeing their profits sharply eroded.
Why has this happened?
We are seeing the dark side of Securitisation, CDO’s and Syndicated lending. These techniques were very popular over the last few years because banks could make a loan to a customer and then sell it on to other banks or investors packaged and chopped up along the way with other loans and/or underwritten with some form of loan protection insurance.
The good side of all this was that it improved market efficiency and allowed people with money to be able to reach borrowers they could not get to normally, (e.g. a French investor could effectively lend money to Americans wanting mortgages).
The dark side was that there was no clear line of sight as to who had what risks. Banks panicked and assumed the worst of everyone, ( i.e. they knew there were some bad loans, sub-prime American mortgages) which were not going to be repaid but nobody knew who was the lender because they had been so chopped up, repackaged, traded, sold and insured by different banks and insurance companies. Banks then took the (overly) cautious view that everybody had all of them. This is a gross exaggeration, but in the absence of knowledge is a prudent common assumption.
Unfortunately it is going to take quite a time for the industry to unravel the information web about loans, CDO’s, securitisation, credit insurance etc to be able to bring some knowledge to the table. So bankers will still be very cautious about lending to each other for some time to come.
Credit Crunch – so what for IT and Operations
There are two main areas of change as a result of the credit crunch for IT and Operations;
- Stop / Run down programmes
- New MI based on Capital
Stop/Run Down Programmes
Over the last few years banks had started investing in departments and systems to facilitate the “distribution” of loans by Securitisation and CDO’s. The Credit crunch has effectively stopped dead in its tracks the Securitisation and CDO activity; by implication the departments and IT projects to support Securitisation and CDO’s will also have to stop – there is no business logic to their retention.
New MI based on Capital
Because it has been easy for banks to sell on loans to other investors via securitisation and CDO’s banks have not really had any constraints on how much they could lend other than customer demand. Because of the credit crunch banks will be limited to lend only what their own resources (shareholder capital, retained profits and customer deposits) can stand.
This will place greater emphasis on the return of capital (ROC) whereas before the emphasis was more on income. We should expect to see much greater demand for ROC information of all levels of the bank (from individual lending officers and branches up to Divisional Chief Executives).
Longer term we could expect to see more industry level developments to re-open the now closed CDO and securitisation markets. This will probably require some form of exchange based or regulation based solution to creating greater transparency on exactly who is exposed to what risks. For example it will probably involve individual banks revealing (either to a regulator, a rating agency or a market) much greater detail about their holdings of certain types of product and their characteristics (e.g. how much mezzanine AAA fund XYZ uninsured do they hold – directly or off balance sheet?).