Thursday, September 25, 2008

Is our Reserve Bank worried? You bet.

From today's Financial Stability Review

"Over the past year, the US financial system has faced its most challenging conditions for many decades, prompting exceptional responses from the US authorities. In the early phases of the turmoil, the main concern was liquidity, with inter-bank spreads, particularly at longer terms, increasing sharply. The Federal Reserve, and other central banks, responded to these tensions with a number of measures that helped alleviate tensions in money markets. Attention then turned to specific institutions’ difficulties associated with sub-prime related products.

These pressures prompted the US authorities to: assist with the sale of the ivestment bank Bear Stearns; place the government sponsored housing enterprises, annie Mae and Freddie Mac, under conservatorship; and provide the world’s largest insurer, American International Group, with a secured line of credit up to US$85 billion. More recently, the authorities have announced several major initiatives intended to provide a comprehensive approach to relieving systemic stress in the financial system. These initiatives include a plan to purchase up to US$700 billion of troubled assets from banks with significant operations in the United States, and insurance arrangements for short-term money market funds. In addition, and reflecting spillover effects to the global financial system, the Federal Reserve, in collaboration with other central banks, has introduced new international swap agreements. ..

At the time of writing, it appears that the most recent announcements by the US authorities have seen sentiment improve somewhat in a number of markets. Nonetheless, conditions remain strained, with uncertainty and risk aversion still at elevated levels and concerns persisting about the capital strength of a number of the world’s largest financial institutions.

At the centre of the problems in the global financial system has been a marked reduction in confidence in many financial institutions. One important reason for this is that investors have been uncertain as to the exact value of the assets on many financial institutions’ balance sheets and, as a result, about these institutions’ underlying capital strength. As many commentators have noted, reducing the opacity of banks’ assets and increasing the level of capital in the global banking system are key to resolving the current problems.

The recent difficulties and the high level of risk aversion come after a number of years in which investors were prepared to borrow heavily to buy risky assets at fine margins. With the pendulum now having swung the other way, the adjustment is proving to be more difficult and costly than many had expected a year ago. Risk margins on many financial assets have increased to historically high levels, and investors are seeking to reduce leverage and are eschewing asset classes which up until a year or so ago were in extremely strong demand. This cycle has been reinforced by financial institutions which up until recently were eager to provide, on very favourable terms, the leverage that investors sought but are now tightening lending standards and becoming much more cautious about providing credit to both households and businesses.

An important factor weighing on a return to more normal conditions is the deterioration in various property markets, particularly the residential property market in the United States.

Declines in property prices, together with the greater uncertainty within the financial system, have increased the risk of a damaging feedback loop running from the financial sector to the real economy and back to the financial sector. Rebuilding confidence in the financial system is obviously important here. From this perspective, the recent initiatives by the US authorities are to be welcomed."