This Intervention Is Not A Cure-all

Sydney Morning Herald

Tuesday October 14, 2008

Malcolm Maiden mmaiden@theage.com.au

FIRST, the good news. The elevation of regulatory intervention to include insurance for inter-bank borrowing should combine with government purchases of bank shares and takeovers on an as-needs basis to put big new foundations under the global banking system.

If they are put in place quickly and carefully, the twin pillars of bank share buy-ups and bank borrowing guarantees (sold to the banks rather than given away, to reduce the moral hazard) should ease fears that emerged in September that the entire banking system would collapse, bringing the pipelines that supply finance to commerce and industry down with it.

And to the extent that those fears were a major force in the sharemarket slide that pulled the markets down by 20 per cent in six weeks and doubled losses since the crisis began, sharemarkets are entitled to rally.

And now the bad news. This intervention may be unprecedented, but it is not a cure-all. In some ways, it only rewinds the clock to September 15,when Lehman Brothers filed for bankruptcy.

The US Government's decision to allow Lehman to fail shocked the banking world. The extent of the losses the crisis was producing and their exact location was one of the "known unknowns" before Lehman's collapse, and when the Bush Administration allowed Lehman to fail, it as good as told the banks that they and everyone exposed to them in the minutely cross-referenced global system would harvest whatever came out of the exposure they took to counter-parties - other banks.

Bank-to-bank lending began to dry up as bank bosses responded to that threat by hoarding cash. The fuse of financial fear was burning brightly, and a volte-face by the US Government days later when it nationalised the AIG insurance group failed to extinguish it.

It has taken a month of urgent maneuvering by western world governments to come up with the double-edged response.

The Irish Government came up with the idea of blanket deposit protection a week and half ago, and that has become a gold standard that governments including Australia's have replicated.

Britain's intervention last week refined the model by proposing simultaneous equity injections into its banks (HBOS and RBS are the main targets), and a government guarantee on British bank borrowings in the wholesale market.

The British model is also becoming a global standard, with the US for example signalling it will buy equity in banks as and when necessary, Australia announcing on Sunday that it would not only guarantee deposits but also guarantee term funding, and the European Union yesterday announcing the same.

The US needs to follow suit with a borrowing guarantee, and that could take time.

But it seems that the world's governments are putting a floor under the banks. That should get some inter-bank lending flowing, and that's a good thing.

But big questions that were asked before September's crisis within a crisis remain unanswered.

The non-bank debt markets remain closed, and propping the banks themselves only attacks that problem at the margins.

Corporate demand for funds that was being satisfied by the securitised debt markets until midway through last year is being redirected to the banks. They need more capital to service this demand, but actually have less than they did a year ago, because their loan losses have not been totally replaced by new capital raisings.

The latest government moves will swing new capital to banks, and support bank lending, but it is a question of timing, and extent: the credit and capital shortage is likely to persist for some time, creating more drag on growth.

The status of hedge funds, private equity funds, property groups and the shadowy $US60 trillion market for collateralised debt obligations is also still unclear. Much of the suspected contamination lies in areas of the economy that are outside the officially regulated finance sector.

The latest initiatives may well have prevented the metamorphosis of the crisis into a disaster, and with Australia's S&P/ASX 200 index and S&P/ASX 100 Industrials indices delivering dividend yields of 5.91 per cent and 7.45 per cent pre-tax respectively there are grounds for investor enthusiasm.

Remember too that there are compensatory movements, even in crises: the sudden descent of the Australian dollar is a product of commodity price weakness for example, but boosts commodity export revenue, in $A terms. Lower commodity prices reduce input costs, boosting profitability and offsetting the weakness in demand that is pushing commodity prices lower.

But the clean-up of this mess has only just begun: it's going to take years.