Funding Markets must be made more stable

As recently as 4Q09, the European Central Bank was dealing with challenges in the funding markets, noting that, “Funding liquidity problems continue to bring pressure on the major banks’ operations. While the conditions have improved substantially in most funding segments throughout 2009, including the money markets, some of these institutions and parts of the broader euro area banking system, remain reliant on temporary support measures extended by the Eurosystem and governments.”[1]

All regulators have come to a greater appreciation of the importance of the funding markets, not only those at the largest and most powerful central banks. In late January, 2010, Governor Yves Mersch of Luxembourg’s central bank described how the crisis in the real economy was triggered by a sudden collapse of the interbank funding markets.

Central Bank of Luxembourg: What was most surprising in the recent crisis was the role played by liquidity. In retrospect, it is easy to conclude that it should have been monitored more closely and that pro-cyclical behaviour needed to be mitigated more effectively. … The financial crisis initially appeared in August 2007 as a sudden shortage of liquidity in the money market.. … As the inter-bank market dried up, banks found themselves hoarding cash to rebuild their liquidity buffers. This induced them to tighten credit standards, posing the risk that they might cut back loans to firms and households, transmitting the financial crisis to the real economy. [2]

In a speech by Norwegian central banker Jan F. Qvigstad, the importance of “funding stability” was again emphasized in unequivocal terms:

Norges Bank: The global financial crisis has revealed weaknesses in the financial system. In retrospect, it is clear that financial sector regulation was not adequate. Regulation was primarily designed to ensure that individual banks had sufficient equity capital to protect lenders and depositors against losses, rather than ensuring stability in the system as a whole. For example, there were no requirements stipulating the size of liquid assets a bank must hold to weather periods of failure in market funding. Nor were there any minimum requirements as to funding stability. [3]

Using the case of Northern Rock as an example, Mr. Qvigstad points out that the bank’s portfolio of mortgages was “not particularly exposed to risk.” However, big risks existed on the liability side of the bank’s ledger. Northern Rock had funded its long-term asset growth with too much reliance on short-term liabilities, in a misguided strategy reminiscent of the 1990’s American thrift crisis. A run on the bank, the first in nearly 150 years for a British institution, resulted when depositors lost confidence upon learning that the bank’s inability to roll over its short-term debt had forced it to seek government assistance.

“Other important questions,” explained Mr. Qvigstad, “are whether systemically important banks should be subject to tighter regulation and how to reduce the procyclicality of bank behaviour. In a world with a global financial marketthere are limits to how far a single country can go it alone. International coordination is important for new regulations to have the intended effect.”