Credit Crunch: How Can the Industry Assure Liquidity in the Banking System?

For years, the difference between LIBOR and treasury bills was relatively low. The average spread from August 2001 to August 2007 amounted to 0.26%. From September 2007 to September 2008, however, the average spread rose to 1.38%. On 19 September 2008, it surpassed 4% – the highest spread ever in recent history. It is a clear sign that banks are not willing to lend money to each other. Trust has disappeared and everybody is opting for the safest borrower – the US Treasury. If banks are not willing to lend to one another, the financial market will dry out and corporations will have tremendous difficulties obtaining any financing. The bank crisis is spreading to the rest of the economy and the bank crisis is now becoming a general crisis.

Figure 1: Treasury Bills (four weeks) and LIBOR (one month)

Source: Federal Reserve

Figure 2: Spread Between Treasury Bills and LIBOR

Source: Federal Reserve

Whether the US government’s US$700bn rescue plan will work remains to be seen but do we have any alternatives? We could, for example, temporarily waive the market-to-market principle whereby the balance sheets of various banks would improve immediately. To add liquidity, the US Treasury could purchase various distressed assets as a part of a swap transaction. If the US Treasury paid too much for the assets now, it would obtain more back when the second leg of the swap is due in the future. What would be much simpler and more effective, however, would be to just provide government guarantee of interbank loans to unfreeze the lending squeeze.This article outlines another supplementary measure that could help to restore trust and ensure the proper functioning of our financial system.

The Alternative

In the interbank market, every bank lends and borrows money from each other. The volume is growing by the minute. Bank A is lending money to Bank B, Bank B is lending money to Bank C, Bank C is lending money to Bank D, and Bank D is lending money to Bank E, etc. When Bank A obtains a deposit from its customer it can, in the simplest case, lend directly to another customer but it could also deposit this money in the interbank market by lending it to Bank B. The initial deposit of, let’s say, US$1m can create much bigger interbank balances (see the example below in Table 1). But, in this example, how was the US$4m created? It can happen when one bank lends to another bank before the ultimate bank lends to the commercial customer or private individual, or it can also happen over time.

During the term of the initial deposit or loan, banks make many funding decisions that ensure the liquidity of the system but also increase exposure to each other. For the last 40 years, this system worked perfectly. Sometimes one bank went bankrupt but, overall, banks applying the counterparty limits could manage the exposure fairly well. But when the credit standing of not just one but many banks is questionable, this form of liquidity transfer does not work.

We need to take the stress out of the system. One possible solution would be the creation of a clearing centre. When one entity borrows and lends to the clearing centre, the exposure of this entity is going to be nil. Loans from and to the same entity (in this case, the clearing centre) offset each other. Table 2 shows that the initial exposure of the banking system is limited to the initial deposit, in this example US$1m.

The clearing centre concept reduces the exposure dramatically and if it has a high credit standing as well, the exposure is further reduced. If all banks start to enter directly into transactions with the clearing centre, this would require tremendous infrastructure to facilitate many transaction. It would also take incentive for the market makers to enter into transactions with the clearing centre. The market makers will encourage other parties to deal with them using their interbank rates: they borrow money from other banks at their bid rates and lend to other banks at their offer rates. We, therefore, need a modified clearing concept.

Introducing a Modified Clearing Concept

In the modified clearing concept, the banks enter into the interbank transaction as today, but after the transaction is executed they notify the clearing centre that they have entered into the transaction on behalf of the clearing centre. The loan from Bank A to Bank B becomes a loan from Bank A to the clearing centre and loan from the clearing centre to Bank B. Legally, the banks never entered directly into any transaction, the transactions were only with the clearing centre. The lender should have the responsibility to inform the clearing centre about the transaction. If it fails, it loses the protection. The clearing centre should protect/settle only the principle amount, not the interest. This will simplify the procedure and probably, over time, banks would start to deal using the discounted papers and the issue with interest payment would be resolved (take a look at the commercial paper market).

As shown in table 2, the exposure that banks add to the system is offset when the bank borrows and lends the same amount from/to the clearing centre. During the time when the bank is borrowing money from the clearing centre it has to pay a small fee for the protection. This fee should reflect its credit standing and provide incentive to reduce the outstanding amount as soon as possible. For example, let’s say Bank B borrowed US$10m for one month from Bank A. According to the modified concept, this transaction becomes a US$10m loan from Bank A to the clearing centre and a US$10m loan from the clearing centre to Bank B. One week later, Bank B lends US$10m to Bank D for three weeks. Now, Bank B’s exposure with the credit centre is nil, correspondingly it will pay protection premium for only one week.

How Could We Create and Operate this System?

1. First, we need the clearing centre. Banks or insurance companies, possibly government agencies, could purchase participation shares. There should be two types of shares: share type A should be paid immediately and share type B, for substantially higher amounts, to be paid when necessary. This would increase the credit standing of the clearing centre and provide the incentive for every bank to work with it.
2. Any bank that would like to participate in the system has to apply for it. During the application process, the credit limit will be established and banks will have to pay a yearly participation fee. The clearing centre will continuously review and adjust the granted credit limits.
3. Any bank can check its credit limit with the clearing centre. The lending bank, however, can only assume that the counterparty has enough credit limit. Therefore any transaction that the lending bank enters on behalf of the clearing centre has to be verified/approved by the clearing centre. The transaction will be automatically approved when the credit limit is available. Since the borrowing bank can check its available credit limit in advance, rejection by the clearing centre can be avoided.
4. The available credit limit can be checked continuously. At the end of each business day, the clearing centre will inform borrowing banks which amounts they have to settle at various maturities.
5. Any settlement will be net settlement. At maturity, if a transaction was not offset by another transaction, the borrower has to pay the due amount to the clearing centre. The lender will receive the net amount from the clearing centre, as per standard payment instructions.
6. The borrowers will pay a monthly fee based on the outstanding amount, time involved and their credit standing. Lenders will not be charged any fee.

Conclusion

It should be possible to establish this clearing centre concept relatively quickly. Administrative costs should also be relatively low using today’s available Internet technology but it will be crucial to establish correct credit limits. Limits should not be too low in order to provide enough liquidity to the system and not too high so as not to expose the credit centre against any individual borrower. Shareholders of the clearing centre will have to approve the credit limit process and it could utilise the available rating services.

This concept could provide stability and prevent further disruption to the financial markets as a result of the liquidity squeeze – limiting the impact on the economy and protecting US jobs and savings. It will also ensure that the financial markets function more effectively in future because it will take risk out of the system in an efficient and market compatible way. The revived banking system will be able to serve the economy more effectively and ensure prosperity for everyone.