Wednesday, December 12, 2007

Coordinated Central Banks Liquidity Injections: Too Little Too Late To Address the Fundamental Problems of the Financial System

Given the worsening of the global liquidity and credit crunch – with a variety of short term interbank Libor spreads relative to policy rates and relative to government bonds of same maturity being even higher recently than at the peak of the crisis in August – it is no surprise that central banks were really desperate to do something.

The announcement today of coordinated liquidity injections by FED, ECB, BoE, BoC, SNB is however too little too late and it will fail to resolve the liquidity and credit crunch for the same reasons why hundreds of billions of dollars of liquidity injections by these central banks – and some easing of policy rates by Fed, BoC and BoE – has totally and miserably failed to resolve this crunch in the last five months. What was announced today are band-aid palliative that will not address the core causes of this most severe liquidity and credit crunch.

There has some heated debate in recent weeks on whether the liquidity crunch is due to:

a) short-term year end liquidity needs (the “Turn”);

b) a more persistent liquidity risk premium;

c) a rise on counterparty risk and broader perceived credit problems of counterparties; i.e. serious problems of insolvency rather than illiquidity alone.

d) a more general increase in risk aversion due to severe credit problems and information asymmetries (risk aversion due to uncertainty about the size of the financial losses and uncertainty on who is holding the toxic waste of RMBS, CDOs and other ABS products);

e) the failure of the monetary transmission mechanism in a financial system where most financial institutions are now non-bank and thus do not have direct access to the central banks’ liquidity or lender of last resort support.