By Hilaire Gomer

Liquidity rhymes with stupidity, not two words that went together until recently.

Liquidity only became an issue with the credit crunch. Now European banks are suffering what US banks suffered in 2007/2008 – a liquidity shortage.

“The marketplace is saying this isn’t just an Italian problem, this is becoming a European problem. Liquidity is vanishing in Europe,” commented Laurence Fink, CEO of global asset manager, BlackRock in November 2011.

On 30 November the world’s central banks announced a plan designed to
support global banks, making it cheaper for banks to buy US dollars which could help hugely to break the liquidity log jam.

Although liquidity at the moment is less of a problem for banks in the UK because back in 2009 checks and balances began to be put in place, it is a real problem for European banks and beyond. Recently the Reserve Bank of India, under pressure from traders, finally released liquidity into the money markets, using bonds. Sweden has announced that it wants its banks to make their assets and liabilities match better to improve the situation ahead of Basel III.

The liquidity available in Europe in 2008 has gone. Whereas US banks got into subprime mortgages, in Europe the banks managed to increase their credit by buying government debt from shaky economies like Greece and Portugal. European banks’ balance sheets, hugely leveraged, are in a much worse state than US banks’. These countries’ bonds were once high quality but now Greece and Portugal are in junk status.

Ben Bennett, credit strategist at Legal & General Investment Management
comments: “Given the liquidity problems, we are now seeing something similar to the circumstances which occurred in 2008. After a partial recovery back then, everyone stopped lending. Now the interbank rate (Libor) has been going up with the fears for the euro and Greek debt. The result is that institutions are being extra careful and there is likely to be a further slowdown in the offing.”

He adds: “The current liquidity situation, though less dramatic, is in fact worse than Lehman Brothers was.However, it is solvable. We need growth, but there has to be austerity too, and that by definition makes growth difficult.”

What is the solution to the immense problem of bank liquidity? Banks have been improving their reserves and balance sheets. There has been quantitive easing (QE) on a massive scale, with the government approaching £2 billion in gilt purchases to provide liquidity. The banks could find new sources of savings to borrow, governments could try to slash their deficits further and, finally, the European Central Bank (ECB), until now concerned with the plight of the euro, could print money.

“The ECB has paid more attention to bank funding in the last 18 months and it is printing money, though it says it isn’t, but in the last six weeks or so it pushed €350 billion (£299 billion) into the system,” comments Michael Howell head of liquidity research at CrossBorder Capital. “This is something, but it remains a fairly crude fire engine job.”

Popular with banks in the battle for liquidity are liquidity swaps which are designed to help lenders improve their funding base and the quality of assets on their balance sheets as they try to escape the liquidity support created by central banks during the crisis. But the Financial Services Authority (FSA) is wary, much to the frustration of banks and insurers which have both being using them.

The FSA, and other authorities, are concerned that banks, insurers and
pension funds trade so much using instruments like liquidity swaps that they may become indistinguishable and risk their survival. Also, there is concern whether insurers and pension funds do sufficient due diligence on the swaps. So some commentators think that financial stability regulators need to ensure that insurers have a diverse asset base so that there are no concentration and correlation risks with banks.

Credit Suisse research reported in November that it found the main mechanism that was effective in providing liquidity recently was the Credit
Guarantee Scheme, whereby the government guaranteed unsecured term funds.

As a result of the liquidity crisis the third Basel Accord was agreed in Basel, Switzerland in 2010. This is an important new set of global banking rules, with liquidity stipulations presented for the first time. The first rule - the liquid coverage ratio - is a buffer which insists a bank has enough liquid assets to survive 30 days of stress – and it won’t be implemented until January 2015.

The second buffer is the net stable funding ratio whereby a bank has to be sufficiently stable to survive a whole year of stress. Different long term assets have to be aligned in a bid to reduce the bank’s wholesale funding.
The rules are designed to ensure that banks reduce their risk exposure and have sufficient liquidity to survive another financial crisis and not suffer the fate of many financial institutions, including RBS and Northern Rock, due to insufficient funding.

The banks, institutions and the UK government welcomed the accord, but, as Danny Cox, head of advice at consultants Hargeaves Lansdown says: “The banks are between a rock and a hard place. On the one hand they are being told to give credit to SMEs (and there is greater risk to doing this these days) and at the same time they are having to raise their capital requirements to fend off financial fallout.”

The UK Treasury select committee has voiced anxiety that banks’ lending ability is being held back because they are required to hold liquid assets - government bonds and to hold more of them than they can sell easily in a crisis.

Andrew Tyrie, Conservative MP and chair of the committee, says: “The
banking crisis in the UK was contained in 2008 by recapitalisation of ailing banks and by large-scale provision of liquidity by the government and the Bank of England. Had emergency action not been taken, the present economic situation would have been far worse than it is.”

He continued, “Bank credit in the UK contracted by 7 per cent in the year to the end of August. The squeeze on bank liquidity is running the risk of continued credit contraction, setting back the prospects of economic recovery.”

Tyrie made it clear that banks should be encouraged to operate with state support. But, attempting it too quickly, in a hostile international economic environment, could risk setting economic recovery back for benefits that were unclear. If that were to happen, a second crisis might come to be seen as having been aggravated rather than alleviated by the actions of regulators.

QE in the UK and in Europe has providing billions in liquidity. But the ECB is not rushing to copy governments and UBS research reckoned that the ECB won’t provide QE until government backed stability bonds are underway.

In the study, UBS comments: “Assuming we get term funding guarantees and stability bonds (big ‘ifs’), banks will still need to shrink to meet onerous incremental regulatory demands and to adjust to what in any event is a more risky operating environment. The system’s survival is the real key to the debate.”

And what about the credibility of the FSA? The easy jibe is that the FSA never saw the storm coming in 2007-2008. One commentator put it like this: “The FSA knows about the micro workings of banks but has no idea what is going on at a macro level. The FSA has been good at telling the banks to cut risky lending.”

Tyrie has also wondered which regulatory body would be responsible for liquidity rules given that the FSA is being broken up and a new Prudential Regulation Authority is being created: “We cannot afford a repetition of what, at the start of this crisis, became known as regulatory under lap.”

The sale by the UK government of walking wounded Northern Rock to
Virgin in November (at a considerable loss), could be interpreted as the Chancellor deciding to sell the bank now rather than waiting until the 2013 deadline, because the markets could be a lot worse in 2013. Also, the government has still to offload its interests in Lloyd’s/HBOS and Royal Bank of Scotland.

Liquidity Risk

Liquidity risk easily becomes a financial risk if liquidity is uncertain and it compounds other risks like market risk and credit risk. If a bank finds its credit rating lowered or has big cash outflows then traders or counterparties will be chary of trading with that institution. A bank would also have problems if certain markets cease to be liquid.

Banks now have heightened risk awareness as they search for sufficient funding - even Germany bonds are deemed unexciting investments - and there is a concern that despite desperate measures, bank funding will dry up ahead. The consensus is that the ECB must become more involved with the crisis and continue to print money. The price for this is rising inflation.

There’s a new emphasis on risk management inherent in Basel III. It
involves the introduction of a robust risk management framework. There has always been a tension between finance and risk management departments in banks and many feel that this is likely to increase post Basel III, but having said that, the accord could make risk management more effective.

At bottom there is the fear in the UK government and in the City that the
eurozone could soon make today’s worries look like a picnic.

At a British Bankers Association conference recently there was a
consensus that banking reform needed to be both comprehensive and lasting, with standards in risk management needing to be universal.

Professor Moorad Choudry, head of business treasury at RBS, said he could see no downside in every bank sharing a common business profile, with a conservative liquidity policy and a chunky capital base.

He commented, “What that consistent approach will bring is much needed confidence in the system. And that confidence will stabilise us when we’re back in the bull market ring.”

No doubt the Chancellor would agree with him and he announced in November that the UK government would guarantee £20 billion of UK bank debt over the next two years in a bid to unbundle credit markets and siphon cash to SMEs.

Meanwhile The Bank of England continued with its efforts to return to a liquid market with a fresh £75 billion of QE announced in October.

Maybe the 30 November accord with world banks to help the liquidity process will prove a turning point.

The Italian job
Irving Henry, director of prudential capital and risk at the British Bankers Association examines Italy’s problem which is of course exacerbating
sovereign and banking difficulties.

By giving up its own currency, Italy lost the important backstop on its government borrowing costs that countries that can borrow in their own currency have. This was a key prerequisite for this crisis to take hold.

The lack of the lira goes hand-in-hand with an additional ingredient to Italy’s current predicament: the lack of a flexible exchange rate that could adjust in response to the stop in private capital flows. Such an exchange rate adjustment would improve Italy’s external competitiveness and reduce its income, which in turn would help Italy bring its current account towards balance. Again, the point is that this crisis is primarily a balance of payments problem, not a budget deficit problem.

Italy has along with the rest of southern Europe been dependent on capital flows from northern Europe to meet its borrowing needs. Private capital flows are fickle, and when they stop, a balance of payments crisis can ensue. What we’re seeing in southern Europe is a variation of that.
Italy is trapped in a self-fulfilling downward spiral. Once the necessary conditions were established by not having the safety valve of its own
currency, and once Italy became vulnerable to a stop in private capital flows, thanks to a persistent current account deficit, the dynamics inherent to self-fulfilling crises took hold - and events have followed the logic to the point in which Italy finds itself today.

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