Central Banks Should Not Lose Their Nerve

Source : The Business Times, August 16, 2007

THE debacle in world financial markets can be put down essentially to three things: over-borrowing, over-sophistication and over-optimism - to which can be added a lack of sufficient oversight on the part of financial regulators. It is necessary to view things through this simplifying prism in order to make sense of what appears to be a highly complex chain of events in the world of high finance.

The world has appeared remarkably free of major financial problems since the failure of Long Term Capital Management in 1998, and even the collapse of the IT bubble a couple of years later sent little more than a ripple through the markets. All this lulled investors, fund managers and investment bankers into believing that regulators and central bankers were truly in control of the situation.

Recent events have made it clear that this is not so and that the regulatory lords of finance have been asleep at the wheel or that they put too much faith in the ability of markets to regulate themselves. Or, perhaps they realised that their own indulgence in bailing out the victims of past crises by providing excess liquidity had created a situation beyond their control and simply prayed that things would not go wrong again.

Central banks are supposed to create just enough liquidity to keep the wheels of global commerce oiled, with a bit extra thrown in to accommodate inflation. Problems arise when these same banks decide to throw a lot more money into the pool in order to soften the impact of a crisis (as they did in 1998 and again in 2001).

Bankers are thereby encouraged to take risks, lending to hedge funds, structured finance vehicles (which profit from arbitrage between borrowing cost and yields on exotic products) and so on, safe in the knowledge that the central banks will lend more still if things start looking shaky.

House buyers (or speculators) are encouraged by banks to take out mortgages beyond their means - safe again in the knowledge that they can easily 'refinance' by borrowing from other institutions if their own banks start getting difficult.

Mortgage loans are securitised in order to spread risk among a broader community of investors and ever more credit is created.

Instead of spreading risk, all this encourages greater risk-taking. Those investing in securitised products have no knowledge of the creditworthiness of ultimate borrowers - be they house buyers or corporate entities.

Good credits are mixed up with bad ones in one package and it takes only one shock (such as the predictable failure in the sub-prime mortgage market) to topple the whole house of cards.

At some point, excess liquidity has to be withdrawn from the system without central banks running away from the consequences of their own actions at the slightest whiff of panic.

Otherwise asset prices will get totally out of line with the capacity of the real economy to support them.