This is a particularly challenging time for central banks, especially in industrial countries. They are in ‘crisis management mode’, seeking to contain collateral damage from the liquidity dislocations and designing ‘crisis prevention’ measures that would reduce the probability of future turmoil.
Central banks face many headwinds in delivering a satisfactory and durable outcome, given stagflationary pressures. This is most apparent in the US where the Federal Reserve directly feels the tug of war as it seeks to deliver on its dual objective of countering inflation and maintaining high employment. But it is also an issue for the European Central Bank.
As central banks confront these difficult challenges, they will likely face another complicating issue. Some of the recent crisis management steps will, in themselves, lead to an institutional realignment of the US financial system. Central banks would be well advised to take this into account lest they end up reacting to the world of yesterday rather than that of tomorrow.
New funding window
Against the background of the Bear Stearns debacle, the US authorities opened a new funding window for investment banks on March 16. The window, which is to be in place for six months, was to act as a circuit breaker in the face of massive liquidity disruptions and a loss of trust among financial intermediaries.
It worked. So much so that when concerns resurfaced in June about one of the major investment banks – Lehman Brothers – the company’s equity price sold off sharply but its senior debt obligations did not. And there was no rush away from the company when it came to counterparty risk.
Now, here’s the rub. The success of this action will, in itself, make it difficult for the authorities to cancel the window in September. They may change the terms but they are unlikely to disabuse the markets from the notion that Federal Reserve liquidity now stands behind the investment banks.
Accordingly, the US authorities will have no choice but to impose greater regulatory and capital requirements on investment banks. Indeed, the banks’ new and privileged access to Federal financing will be accompanied by regulatory treatment similar to that being imposed on commercial banks. The result will be a de-levering and de-risking of investment banks – good for debt holders but, by reducing potential return on equity, bad for equity holders.
Heightened interest
Also look for investment banks to react. This will include heightened interest on their part to partner with other institutions who already have access to the cheapest funding of all: that offered by bank deposits. Indeed, prepare for stepped-up mergers and acquisitions, most voluntary and some forced.
What about the vacuum that is left behind in the financial system as the investment banks converge to commercial banks? It will most likely be filled, given the potential for attractive long-term risk-adjusted return in that space, with the main candidates coming from firms that are not subject to comprehensive regulatory oversight. They will be led by private equity and hedge funds with realistic aspirations, maturing institutional structures and, most importantly, an ability to raise permanent capital.
As they look forward to these possibilities, regulators around the world will quickly realise that they cannot sustain the current regulatory separation. Instead, they would be well advised to spend time now thinking about the treatment of those that will likely fill the analytical gap vacated by the investment banks. If they do not get ahead of this phenomenon in a ‘crisis prevention’ sense, they will be forced into clean up operations under their ‘crisis management’ obligations.
Mohamed A El-Erian is co-CEO and co-CIO at PIMCO and author of When Markets Collide: Investment Strategies for the Age of Global Economic Change.
