In the first part of this article we had argued Gordon Brown?s rescue plan is flawed because it capitalised banks before valuing toxic assets. Today, we discuss two more flaws in the Brown plan.
In providing national guarantees to get banks to lend to one another again in the global unsecured interbank money market, Brown made the second cardinal error. The interbank market is a global seamless market in which the largest participants are not just banks, but money market funds, and other holders of cash liquidity such as large corporate treasuries, acceptance houses, pension funds, insurance companies etc. It is not just a national or banking market. National guarantees are a sub-optimal device to get that market working again. They may unblock British banks from lending to one another in London. But they will not unblock them from lending to non-British banks knowing they are not guaranteed.
Even if understandings are such that British banks are comfortable about lending to EU, US and Japanese banks, because of guarantees provided by those other governments, they are still taking unknown risks by lending to non-EU, non-US and non-Japanese banks (i.e. Indian, Chinese, Brazilian, Middle Eastern, African banks, etc.). That is the prime reason that trade financing in these regions is drying up. Banks around the world are no longer prepared to accept cross-border LCs, packing credits, bills of exchange, import and export credits that involve an uncovered risk. National guarantees need to be pooled and triggered by an international authority to make the global interbank market work properly again.
The world?s central banks need to develop instruments enabling them to operate directly in these markets to restore confidence, and make risks in these markets more acceptable, rather than just keep infusing liquidity through banks against any form of collateral. It is not just liquidity that is the problem. It is the continuing lack of confidence within the banking system.
Third, Brown did not address the critical issue of the uncertainty overhang in the credit default swap (CDS) market which restrains banks from lending because of uncertainty about counter-party credit risk at a time of extreme uncertainty. That risk is changing daily. The pricing of CDSs reflects that. Global central banks and regulatory authorities need to get together immediately to create a central clearing corporation for CDSs. Outstanding $33 trillion worth of CDS contracts ($3.3 trillion after netting out) identified by the DTCC should be handled by the CCC acting as counterparty to each side of every bilateral OTC deal. Eventually such contracts should be priced and traded on exchanges. Though this seems complex, it can be done more easily than imagined. Unless the CDS market unfreezes quickly it will continue to act as a brake on credit flows no matter how much liquidity is created.
Haste always makes waste. Trying to be too-clever-by-half (a fundamental failing in Brown?s psychological make-up that reveals itself every time a crucial juncture is reached) results in his ending up looking daft. Just a month after the Brown Plan was unveiled and propagated it is becoming apparent how half-baked it is. It has put a band-aid on a severe open wound that is still festering. Is it any wonder then that, despite a sense of brief respite after its arrival, the mood has reverted to one of growing despair, doom and gloom?
Perhaps the market?in still trying to find that elusive bottom?is signalling something we are not sufficiently sensitive to. It may be signalling that, despite everything that has been done so far, the market has no intrinsic faith in political leadership anywhere; particularly in the US, UK, EU and Japan. While everyone is looking to governments to prevent collapse and solve the problem, no one has any faith in the political pygmies presently running them. Will the incoming Obama administration make a difference? One can but hope.
The market has certainly lost faith in banking leadership; and India is no exception. It is now losing faith in industrial leadership to put things right. Yesterday?s masters of the universe, whether bankers or industrialists, are today?s nervous breakdowns. They are asking for help of every sort from every government, to cover up for poor strategic decisions and failed business models, without realising what their demands are adding up to. Governments in a panic seem willing to oblige them, regardless of future consequences. Their actions are having unintended consequences (like the dollar appreciating when it should be depreciating) that will continue to delay the kind of global adjustment that is so necessary to put this debacle behind us in a decisive fashion.
(Concluded)
?The author is an economics and corporate finance expert. He chaired the high-powered committee on making Mumbai an international financial centre