Alasdair Macleod – 17 September 2009
It seems that broad money in the US is contracting – seems, because the Fed stopped publishing M3 figures some time ago. However, bank credit has contracted in the last three months by an annual rate of 14%. The cash is piling up at the Fed, despite its efforts to get lending going again. Banks excess reserves have risen in the last year from $2bn in August 2008 to $823 billion today.
The credit contraction is the fastest since the Great Depression, and various commentators are extremely alarmed. These commentators, including eminent monetarists, seem to think that the mistakes of the past can be avoided. But for this to be true, you have to control human reactions. The human reaction in this case, has moved from greed to fear, as indeed it did in 1931. Banks are now afraid of losses, so they want to reduce their lending. In 1931, depositors who were offered low interest rates, decided that this was not sufficient reward for the risk that their bank might go bust, so they held on to folding cash. Banks starved of deposits had to de-gear. During 1931, currency and bank deposits contracted from $53.6bn to $48.3bn, an annual rate of 9.9%; only two thirds of today’s 14% rate.
Given that bank deposits are now generally underwritten by governments, cash-under-the-bed is not the problem today. The human psychology is in the banks, which are over-geared and worried about bad debts. Actual gearing levels are extremely opaque, with accounting standards having been modified to give banks “accounting flexibility” – hiding losses to you and me. However, we know that gearing is actually rising, because banks have been forced to consolidate some of the off-balance sheet vehicles set up earlier this decade to avoid capital constraints. They have also had to absorb massive losses, which wipes out primary capital.
We are also told that outstanding derivative positions are standing at $426 trillion (The Daily Telegraph, 14th September). The bulk of these are on bank balance sheets, presumably because banks find derivative trading more profitable than bank lending, or they are using instruments such as credit default swaps to cover lending risks. Either way, they are not much interested in the lending business.
Monetarists insist that suitable measures can resolve this problem. They abhor the encouragement given to banks to de-gear, but given some estimates that true bank gearing on average may have risen to as much as 40-50 times (we have no way of knowing this, given the “accounting flexibility” sanctioned by regulators) this advice seems unwise. It doesn’t matter what the monetarists recommend, bankers are very frightened humans.
While the thought that banks are so fantastically geared and that this gearing may still be rising is terrifying, it does give us a clue about what is likely to happen. If we regard bank gearing numbers as being a perverse financial bubble, we can visualise it coming to an end spectacularly. It could be derivatives that cause this, but equally it may simply be an asset class commonly held as loan collateral, such as commercial real estate. If for a $1 loss, $50 of lending is wiped out, this will set off a financial avalanche.
Doubtless, there will be some banks who initially will heave a sigh of relief, having covered their lending risks with derivatives. This relief will only last so long as their derivative counterparties are still standing, and unfortunately, it is a feature of off-market derivatives that a chain of many banks are often involved in a single position.
Meanwhile, financial markets continue to recover, and bullishness is pretty well universal. This is at odds with developments behind the scenes, reflected in statistics such as contracting bank credit. It feels like September 2007, when markets were still rising to new peaks in spite of paralysis in the interbank market in late August, and in spite of the fact that collateralised debt obligations were collapsing.
Fasten your seat-belts for Credit-Crunch II, a box office hit showing at a bank near you soon.