Posted by: Dirk | November 10, 2009

The trouble at the banks

During the Great Depression, banks broke down in large numbers. Afterwards, it was argued that the Fed let these banks fail by not increasing the money supply and keeping interest rates to high. Today, we can see why this argument is not valid.

This time it’s different. The ZIRP (zero interest rate policy) ensures the lowest nominal interest rate possible while quantitative easing (expanding monetary supply) ensures liquidity. However, instead of the banks getting better they seem to stabilize only, and now there are some more dark clouds on the horizon.

First let me explain that the nominal interest rate is not what all banks pay for their capital. The Fed accepts only very good assets as collateral when handing out additional money (although lending standards have been eroded there as well, with the Fed taking on troubled assets). So, if a bank with low quality assets needs to roll over debt, the interest rate it pays is probably going up, because the loan has to be coming from the financial market, and not from the central bank. At least the FT says so, reporting on an assessment by Moody’s.

This means that monetary policy is still without traction. The interest rate which banks face when rolling over debt, which is the most important one we are looking at right now, is different from the nominal interest rate set by the Fed. The only way to save banks now, should they go under water in the next months or years, is by direct transfers of capital – again. We saw this happen last year, we might see it again in 2010.



The above graph pictures not the LIBOR or any banking related interest rate but the one that matters to companies of a specific rating by Moody’s. You can see that although the nominal interest rate is near zero, relevant interest rates for firms in the real economy are not. I guess that the same goes for financial firms, since they hold a portfolio of assets stemming from exactly these real economy firms.

What has helped banks a lot is that the prices of financial assets have gone up worldwide. However, this is only because of the mother of all carry trades, as Nouriel Roubini calls it. Since you can lend at zero interest rate from the Fed, banks do that and then get out of the dollar by buying assets abroad. This is probably what drives the dollar down and global asset prices up. This takes some pressure of the balance sheets, but then: is this sustainable? Roubini says: nope.

When the dollar has declined a lot and bottomed out, the carry trades will unravel as everybody gets back into dollar. This race will drive the dollar up again and global asset prices back down. However, that also means that asset prices today are inflated, and everybody knows it. So the interest rates that banks face are probably not coming down, even though their balance sheets look nicer.

Roubini concludes:

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.


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