The right number of banks that should fail when a credit bubble bursts may not be zero
'A FURTHER important cause for alarm was the danger that the troubles, if not solved, would be transmitted through a domino effect to the many other secondary banks which, with much vulnerable short-term borrowing and many assets tied up in the increasingly troubled property industry, were themselves showing signs of being at risk in the harsher new economic environment.'
Eyes on central banks: The European Central Bank (above) has kept monetary policy on hold last week. Traders and investors are betting the Fed will also blanch, with futures and options prices suggesting almost a 90 per cent chance of a US rate cut next week. Sounds like an apt, if somewhat wordy, description of the current money-market crisis prompted by the collapse of the US sub-prime mortgage market, doesn't it?
Instead, the passage is lifted from The Secondary Banking Crisis, 1973-75 by Margaret Reid. The book describes how the collapse of a UK mortgage lender called Cedar Holdings triggered a crisis of confidence in the banking system, requiring a Bank of England bailout.
Many of the similarities between today's financial environment and the one prevailing more than three decades ago are striking - except for the part where the central bank rides to the rescue by strong-arming a posse into action.
Banking is essentially a confidence trick. Depositors have to be confident they can draw freely from their accounts. Retailers have to be confident swiping a rectangle of plastic in exchange for goods and services will produce a balance transfer in their favour. And the banks themselves have to be confident they and their peers have sufficient assets to meet their liabilities.
For now, that confidence has evaporated as hedge funds and structured investment vehicles and conduits - spawned while the credit-market party was hopping - come knocking at the door for handouts because the music has stopped.
And thus, the banking community wants the central banks to soothe its hangover and refill the punchbowl by cutting official interest rates.
It's far from certain that lower central-bank rates would unfreeze the money markets. Moreover, central bankers are probably willing to sacrifice smaller lenders so the pain is enough to make financiers more cautious about future investments, provided there's no threat to general stability.
The US Federal Reserve and the European Central Bank (ECB) have held special auctions to grease the wheels of commerce with extra cash. They have succeeded in driving the overnight rate for dollars down to about 5.18 per cent from as high as 5.96 per cent, and its euro counterpart to 4.15 per cent from 4.69 per cent.
Three-month rates, though, are stuck at a seven-year high of 5.7 per cent for dollars and a six-year high of 4.82 per cent for euros.
The Bank of England, by contrast, has been adamant that it won't rescue the money markets by accepting low-grade collateral, or by offering three-month cash.
Indeed, the Fed and the ECB were rebuked, albeit obliquely, by UK central bank governor Mervyn King for bailing out commercial banks.
'The provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour,' Mr King said in a copy of testimony he plans to deliver to the UK Parliament's Treasury Committee on Sept 20. 'That encourages excessive risk-taking, and sows the seeds of a future financial crisis.'
Victoria Mortgage Funding Ltd, a UK company that lent about £pounds;300 million (S$918 million) in sub-prime mortgages to British borrowers, was placed into administration earlier this week, the UK equivalent of Chapter 11. Victoria couldn't secure enough funding to stay in business.
Current contagion
That's what should befall financial institutions that ignore the risk of a funding deficit and 'have borrowed short to lend long', as Mr King put it in his testimony. A central bank chief, though, would never be allowed to voice that axiom.
Mr King sounds determined to take advantage of the current contagion to try to extinguish the notion of a 'Greenspan put' or 'Bernanke put', the idea that central banks will always ride to the rescue.
The UK central-bank chief said helping commercial banks salvage their 'risky or reckless lending' is especially dangerous, because it 'encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank'.
The ECB has already blinked, by keeping monetary policy on hold last week. Traders and investors are betting the Fed will also blanch, with futures and options prices suggesting almost a 90 per cent chance of a US rate cut next week.
The Bank of England's approach may be informed by its experience in underwriting the salvage operation that kept the UK financial system afloat more than 30 years ago.
In her 1982 book on the crisis, Ms Reid cites an unidentified commercial banker suggesting the big institutions did too much.
'If we had from the outset allowed two or three of the least respected names to collapse in a flurry of publicity with losses to their depositors, it would have served them right and would have acted like a quick piece of surgery on the City, cutting out the canker and enabling the rest of us to continue the more easily with our normal business,' the banker said.
The correct number of banks to fail when a credit bubble bursts is not zero. If the best way to avoid the mispricing of risk in future is to sacrifice some of the less-prudent lenders on the altar of liquidity, then let the culling commence.
That is especially the case if it erases the perception that central banks will always act as lenders of last resort, even to institutions that don't deserve to survive.
The writer is a Bloomberg News columnist. The opinions expressed are his own
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