Buttonwood
Mismatch of the dayFrom The Economist print edition
Sep 20th 2007
SourceThe new financial system has an age-old problemTHE financial system is built on a fundamental (and ever-present) mismatch. Savers want access to their money instantly, if necessary. But borrowers are usually unable to give it to them anything like as quickly.
The banks have traditionally bridged that gap. But the only way they can do so is to borrow short and lend long. This mismatch makes them vulnerable. That is why governments have imposed regulations on the banks, requiring them to hold reserves against an emergency. But if there is a complete loss of confidence among depositors, there is really not much an individual bank can do (see article). The central bank is usually obliged to help.
One of the reasons why the modern financial system was supposedly stronger than before was the reduced importance of the banks. Instead of hanging on to the loans they have made, they have parcelled them up and sold them on. The aim was to disperse risk; in the case of default, it was better for a lot of investors to lose a little than for a few banks to lose a lot.
In some cases, the repackaged loans have been bought by investors with long-term horizons, such as pension funds. But they do not have enough capital to replace the banks completely, nor do they have an appetite for the riskiest loans.
All the clever types of securitisation and structured products have not eliminated the fundamental mismatch. Someone still has to borrow short and lend long. Northern Rock, the stricken British bank, is a case in point. It is what used to be known as a secondary bank; borrowing the bulk of its money short-term from other banks (and the credit markets) rather than directly from the public to fund its energetic mortgage lending. When the money markets froze, it faced instant problems, since exacerbated by a loss of confidence among its depositors.
Hedge funds are another example. Many will have been attracted by the higher yields available on repackaged, or securitised, loans. But as the yields on such loans fell in recent years, the funds have needed to use more leverage (borrowed money) in order to generate returns that are sufficiently attractive to clients to justify their fees. As soon as yields started to rise (and the price of securitised loans started to fall), the hedge funds needed to cut their positions. The problem has been finding someone to sell to.
Mutual funds have had some exposure to securitised loans. But they have their own funding mismatch (investors can withdraw their money on a daily basis) and a limited desire to buy in a falling market. In the case of one class of mutual fund—the money-market funds—they are terrified of incurring losses that might cause them to “break the buck”, or repay their investors at less than par. So they have stopped buying.
Clearly, the new financial system is still vulnerable to the kind of credit crunch that has been seen through the ages. But instead of the problem starting with the banks, it has been precipitated by a “buyers' strike”.
Yet the banks still end up holding the bag. With investors no longer so prepared to take loans off the banks' hands, they are being forced to hang on to them, or offload them at a loss. In other cases, they are on the hook because they have financed the purchasers of the loans in the secondary market. They may be acting as prime brokers (and thus the main lenders) to hedge funds. Or they may have indulged in a little “regulatory arbitrage”, buying the loans through off-balance sheet vehicles, known as conduits, so they do not need to hold reserves against them. Those loans are coming back on to the balance sheet.
The lesson of all this is that those who believed risk had been eliminated from the system (or even substantially reduced) were being foolish. It has just emerged in different ways.
The remodelled financial system may turn out to have less frequent, but more severe, crises. It has made credit available to more people. To the extent those people then used their credit to buy assets, asset prices were forced higher, increasing the value of the collateral, and making the loans seem safer.
What the world has yet to see is a phase when this benign cycle goes dramatically into reverse. Over the past 20 years, central banks have always managed to stop the rot by cutting rates and restoring confidence.
Logic would suggest that this cannot continue forever, that there must be some point at which the debt burden is too high to be assuaged by lower interest rates. The coming weeks will show whether that point has finally arrived.