Pradeep (Advocate) 16 September 2008

US banking Crisis

can anyone tell me, what exactly is the banking crisis going on in US currently and what is the exact reason for the same

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4 Replies

Lakshmi Narayana (IPR Consultant /Trademark Agent ) 16 September 2008

Dear Pradeep kindl; see the article published in Deccan Chronicle dated 16th 09-2008.

N.K.Assumi (Advocate) 17 September 2008

Dear Pradeep,

This is the position according to Nicholas Dimsdale:

The recent failure of Northern Rock, the mortgage bank, was the first run on a major British bank since the collapse of Overend and Gurney in 1866. Its customers, mainly old, middle-class people, were caught up in a global crisis, which enveloped the banking systems of the US and Western Europe.

The trouble started with problems in the US market for sub-prime mortgages. Unscrupulous brokers granted mortgages to borrowers who, as the saying goes, had no job, no income and no assets. These mortgages of dubious quality were securitised. The repackaged securities, known as CDOs (collateralised debt obligations), were sold on to international banks, who held them in special investment vehicles (SIVs) not shown on their balance sheets. Much of the finance for SIVs came from the issue of ABCP (asset banked commercial paper) in the commercial paper market.

The possibility of default on the underlying US mortgages made structured assets appear increasingly risky. Banks could not find buyers for them. So they had to take increasing amounts of these potentially toxic securities on to their own balance sheets. The result was a squeeze on bank liquidity, which sent interest rates in the inter-bank market sky high.

The Federal Reserve and the European Central Bank responded to the stringency by injecting massive amounts of short term funds. The Fed reduced the Federal Funds rate, its main policy rate, by 50 basis points. The ECB postponed a rise in its lending rate and provided generous liquidity in the markets for overnight money and for three-month securities, and accepted a wide range of assets as collateral.

By contrast, the response of the Bank of England was muted. Assistance came later and was less generous. Governor Mervyn King lectured bankers on the dangers of bailing out banks for unwise investment decisions. The Bank intervened in the overnight market, but it declined to do so in the more crucial three- month market, so opening up a massive gap between its policy rate and market rates.

This put severe pressure on mortgage banks, which depended on the money market to finance their mortgages. Northern Rock did not have the cushion of retail deposits like the larger banks. It ran out of funds, even though its mortgage portfolio was solvent. The announcement of assistance from the Bank to the ailing Northern Rock did not prevent a run on by its depositors. It was only checked when Chancellor of the Excuequer Malcolm Darling promised full protection for the depositors.

At the same time Governor Mervyn King executed an astonishing U turn: he announced support for the three-month market and widened acceptable collateral to include mortgage- backed securities, although such loans would be at a penalty rate. He lost some credibility, in contrast to Ben Bernanke who had not hesitated to make rate cuts despite risks of moral hazard, a rise in inflationary expectations and a weakening dollar.

Liquidity shortage combined with a more cautious approach by banks is reducing supply of finance. In Europe, where the ECB and the Bank of England have not reduced their policy interest rates, the effective rates paid by borrowers in the private sector have risen sharply, generating a credit crunch and expectations of slowing economic growth in 2008. By contrast, in the US the rate cuts made by the Fed may suffice to stave off the threat of recession.

While this financial crisis has hit developed economies hard, the impact on emergent economies has been negligible. The stability of their markets has made them safe havens in a disturbed world. Asian policy makers who suffered in the crisis of 1997, are entitled to feel a certain sense of satisfaction at the present discomforts of western bankers. But perhaps the main lesson to be drawn is that financial innovation, while bringing real benefits, also entails risks of greater financial instability and creates the need for appropriate regulation.

The author, Nicholas Dimsdale is Fellow of the Queen’s College, Oxford