Going with the flow
The Buddhist Way is signposted by samatha – or mental concentration and control of thought and conduct – and vipassana, or knowledge. Banking, meanwhile, is guided by the concepts of capital and liquidity. For banks, liquidity – like some Buddhist koan – is always available unless you need it.
If liquidity is the ineffable essence of being for banks, its absence presents an existential threat that haunts the institutional mindset. Historically, bank failures have almost always been linked to fast-evaporating liquidity triggered by panicked customer demand for cash – a nightmare scenario that most countries now attempt to ward off through deposit-protection schemes.
At the outset of the global financial crisis, the UK saw that nightmare come true as anxious clients queued outside Northern Rock branches to drain their accounts from a bank with almost nothing in the tank.
While the Northern Rock episode provides a vivid recent example, the most perceptive economic writer of the Victorian times, Walter Bagehot, established the still-canonical prescription for stopping a run on banks more than 100 years ago. In his landmark 1873 book, ‘Lombard Street: A Description of the Money Market’, Bagehot laid down the formula for fighting bank runs, asserting that central banks should lend freely at a high rate of interest against good banking collateral.
As in 2008-9, Bagehot’s dictum is in vogue again this year: amid a potential bank crisis and tumbling share prices, calls ring out to the Federal Reserve (Fed) and other central banks to inject the markets with emergency credit.
Ostensibly, the world has made some progress on managing the liquidity conundrum since the financial crisis snap-froze markets in 2008. Indeed, governments, central banks and financial institutions have all taken the crisis’s liquidity lessons to heart as they unite to hose down the gathering economic and market fallout from the pandemic. ‘Go with the flow’ very much appears to be the current mantra.
Massive amounts of monetary and fiscal stimuli are now pouring through financial channels across the world, most of it intermediated by global banks that played the villains of the piece during the last crisis.
Figure 1. Lenders of the last resort1
Detail and region
Discount windows and discount rate
For bank holding companies and banks (US, 2009) (UK, 2009)
Emergency lending to non-banks and lending to support market funding
Commercial paper funding facility (US, 2009 and 2020)
Primary market corporate credit facility (US, 2020)
Targeted long-term refinancing operation (Europe, since 2015)
Funding for lending scheme (UK, since 2012 but now closed)
Various central banks (2009, 2020)
Contingent term repo facility (UK, 2020)
Source: Federated Hermes, as at October 2020.
A thankless task
Backed by governments and monetary authorities, banks have been handed the heroic task of keeping businesses and households afloat as the deadweight of the coronavirus shutdown threatens to sink the global economy.
Undoubtedly, banks face challenges to their loan books as the pandemic drags some business and personal debt under water. Yet compared to the global financial crisis, financial institutions entered this crisis with more ballast and better liquidity-management gauges.
For instance, the Basel III global banking reforms introduced after the last crisis created two new important metrics: the liquidity coverage ratio (LCR), also known as the survival ratio, and the net stable funding ratio (NSFR), which introduces longer-term financial stability targets for banks.
The LCR ensures banks have enough high-quality liquid assets (HQLAs) to “survive a period of significant liquidity stress lasting 30 calendar days”, according to the Bank of International Settlements. HQLAs include central bank bills, supra-government bonds and, with some haircuts, short-dated investment grade credit.
Most financial institutions have significantly shored-up their HQLA buffers since the financial crisis. For example, JP Morgan held five-times the amount of HQLAs in the third quarter of 2020 compared to 12 years before, lifting funding levels from $80bn to $500bn over the period.
Meanwhile, LCRs in European banks sat comfortably over 130%, supported by loan-to-deposit ratios that dropped from about 125% before the financial crisis to an average of 100% in the first half of 2020. In short, the funding gap has closed considerably over the last decade.
Firehoses at the ready
Despite coming into 2020 with well-stocked reservoirs, the scale of the coronavirus crisis has seen further liquidity pumps open – including a new UK lending facility. At the same time, the European Central Bank (ECB) has topped up the collateral pool and set higher incentives for lending to small-to-medium enterprises under its targeted long-term refinancing operation (TLTRO III) program (see the box below).
TLTROs: a helping hand
First introduced in June 2014, TLTROs are ECB operations that provide financing to banks. The ECB sees TLTROs as a core tool and will likely expand and extend them. TLTROs provide a specific subsidy for banks that are potentially overwhelmed by lower rates and – by design – lower loan spreads.
On 24 September, the ECB announced a drawdown of €175bn in its second TLTRO from 388 banks (v €1.31trn from 742 institutions in June). It seems that more money was drawn down by smaller banks this time. This represents another significant liquidity injection that should, in theory, ensure banks are willing to lend (and that the -1% rate is achieved for the next 9 months).
There is no stigma attached to taking this money. For the first nine months, it can be redeployed to the ECB and earn 50bps-worth of carry with no leverage-ratio implications. Once the cash settles, we typically see follow-through demand in the government bond, agency, corporate and preferred senior markets.
In a previously unheard-of move, the Fed opened the quantitative-easing spigot for investment-grade credit this spring. In addition, it has carried our other less-heralded (but equally critical) prime-pumping actions, including corporate paper and repo-market liquidity measures.
Liquidity is there – and we’re going to need it. Both Buddha and Bagehot would understand
“The absolutists of contract are
the real parents of the revolution”
John Maynard Keynes, 1923