Avoiding a Disorderly Deleveraging
The global financial system may be caught in a downward spiral as market and funding illiquidity reinforce each other. The author of CEPR Policy Insight 22 presents a radical proposal that would break the feedback loop by not valuing illiquid assets at market prices under crisis conditions.
Prolonged financial distress, which has now lasted for almost a year, is debilitating the financial system and risking a full-fledged crisis. Central bank interventions have thus far prevented worst-case outcomes, but they have alleviated symptoms rather than the underlying causes. Financial intermediaries are still in the process of shrinking their balance sheets, thus activating a channel of transmission of financial distress to the real economy.
The recent turmoil is a product of deep flaws in banks’ new business model and recent financial innovations. Many proposed reforms may reduce the risk of these events repeating, but most cannot undo the effects of the present crisis and insure a smooth transition. The immediate problem is a spiral of forced deleveraging and illiquidity, as the link between market and funding illiquidity strains balance sheets. Proposed remedies are either insufficient or unsatisfactory, which means that more radical interventions may be required. In CEPR Policy Insight 22, I propose a bold alternative.
Structural problems and medium-term solutions
The current turmoil can be attributed to a business model in which banks would pool and securitise credits that they originated to distribute them and transfer their risks to a myriad of investors. Though the new model promised benefits in credit allocation, new risk-return investment opportunities, and financial stability, it is now known to have suffered from a catalogue of problems. These range from excessive credit due to permissive monetary policies to flaws in ratings agencies’ risk models, from perverse incentives guiding the agencies and bank managers to regulatory failures. While mending those fault lines is an important task that will require international cooperation, it will at best take care of the future, not the present.
Forced deleveraging and the liquidity spiral
The immediate problem is the disorderly reaction to the unprecedented growth of the financial system’s leverage and its exposure to risk. As demand for asset-backed securities has disappeared, prices have collapsed without finding a floor. Banks are reporting losses that strain their capital positions. The loss of market liquidity affecting all classes of debt securities directly or indirectly owned by intermediaries has translated into a sharp decline of funding liquidity, the more so because short-term debt issued on wholesale markets has become a major component of banks’ funding. The forced adjustment of banks' balance sheets could, in the worst case, result in a credit crunch with painful consequences on the real economy.
Can we break the link between the illiquidity of banks’ securitised assets, which prevents their orderly liquidation, and the shortage of funding liquidity, which is the driving force of the negative feedback originating from the process of deleveraging?
For funding liquidity, emergency liquidity support from central banks has helped lower the temperature in the worst moments, but it is not a long-term solution. Setting a collateral value of illiquid securities does not provide a market for them and hence does not set a floor to their market prices; the collateralized securities remain on the intermediaries’ books, affecting the quality of their balance sheets. Capital increases are also insufficient to break the spiral, as injections of capital may prove inadequate only a few weeks after their announcement.
For market liquidity, suggested remedies are equally inadequate. Mandated full disclosure of losses might reduce uncertainty, but unless market liquidity is instantly restored, full disclosure of the situation at time t offers no guarantee that it will be the same at time t+1. Similarly, retreating from marking financial products to market or model during this time of crisis would face a number of difficulties.
More radical solutions
The feedback between market and funding liquidity problems demands more radical pre-emptive solutions. As long as “there is no immediate prospect that markets in mortgage-backed securities will operate normally”, “the situation will improve only if the overhang of illiquid assets on the banks’ balance sheets is dealt with” (Bank of England 2008). In creating its Special Liquidity Scheme, the Bank of England has moved to serve as the “market maker of last resort.”
The scheme allows banks and building societies to swap some of their illiquid assets, including debt securities rated no less than triple A, for specially issued Treasury Bills for up to three years. Eligible securities will be valued at market prices, if available, or, if not, at a price calculated by the Bank, with haircuts for private debt securities. Changes in market prices or in valuations will require re-margining. The credit risk will remain with the banks, so that there will be a loss for the lender only if the borrower defaults and the value of the collateral falls below that of the bills originally acquired in the operation.
Is the initiative bold enough? The scheme does not set a floor for assets’ market prices and uses market prices to value collateral, despite the fact that during a negative bubble they do not reflect fundamentals. Downward instability may moreover occur if haircut discounted collateral values trigger a convergence process for market prices requiring repeated re-margining.
In CEPR Policy Insight 22, I recommend the creation of a publicly sponsored entity that could issue guaranteed bonds to banks in exchange for illiquid assets, drawing on US Treasury Secretary Nicholas Brady’s solution to the Latin American sovereign debt crisis in 1989. This new entity, preferably multilateral, would value assets based on discounted cash flows and default probabilities rather than crisis-condition market prices.
As a firm floor is set to valuation and illiquid assets otherwise running to waste are replaced by eminently liquid Brady-style bonds, funding difficulties and, at the same time, the market liquidity problems besetting the banks’ balance sheets would be removed. Shielding the banks’ assets from the vagaries of disorderly markets is a necessary condition to dispel the uncertainty that prevents a proper working of credit markets.
Luigi Spaventa is Professor of Economics at the University of Rome and Former Chairman of the Commissione Nazionale per le Società e la Borsa (CONSOB). CEPR Research Fellow.
Bank of England (2008), Special Liquidity Scheme, Information, Market Notice, April 21.