By Chris Shaw
The move by central banks around the world to inject liquidity into the system has stabilised (at least for now) global markets, but the action probably means little to the average investor. Noting this, Danske Bank has come to the rescue and outlined just how central banks actually operate and explains their role as liquidity providers to the general banking system.
As Danske Bank points out, the normal course of action for a central bank, be it the Federal Reserve in the US, the European Central Bank (ECB) or the Reserve Bank of Australia, is to adjust the level of liquidity in the banking system.
In the case of the ECB this is done via once-a-week pre-scheduled auctions and monthly tenders, with the level of liquidity being provided based on what the central bank in question estimates will be needed to keep interest rates at or around official levels.
In between these auction days individual banks adjust their liquidity levels by borrowing or lending more money between themselves through what is known as the interbank market, or by getting additional liquidity from investors through the repo market. Repo here stands for repurchase agreements and traditionally take the form of overnight loans but can be of any duration, so in Australia think of overnight deposits and bank bills.
In the interbank market the interest rate is set by the vagaries of supply and demand, as well as by the perceived risk between the banks involved. As Danske notes and the last couple of weeks have demonstrated this, as financial volatility increases the risk of an associated liquidity squeeze also increases, meaning banks want to increase their levels of highly liquid holdings to counter any potential risk to their financial assets.
At the same time they lend less to other banks in the system as the perceived counterparty risk has now increased, meaning very quickly the situation becomes one of higher demand but lower supply.
This forces interest rates higher, as evidenced last week when the announcement BNP Paribas was freezing three investment funds sent European overnight interest rates to 4.6% compared to the 4.0% refinancing rate.
To counter this, the ECB stepped in and injected additional liquidity into the system, in this case to the tune of 95 billion euros. While the injection addressed the liquidity issue, Danske Bank points out the second factor of perceived higher counterparty risks remains and is likely to linger until the crisis has fully passed.
According to Danske Bank an important distinction to make is to not confuse a credit crunch in the interbank market with a general credit crunch, as the latter involves tightening lending to companies and individuals.
While there has been significant evidence of such a tightening in lending in the US housing market and much commentary suggesting it will be far more difficult and/or expensive to borrow money in Australia (aside from the latest increase in official interest rates), the same trend has yet to emerge in the EU thanks to solid company and consumer balance sheets.
But given the global liquidity issue appears far from over, the bank does accept this is a potential development investors should keep a close eye on.
As another point of note, Danske Bank suggests the liquidity issues being felt should not impact on the monetary policy actions of central banks as the aim of central banks at present is to steer interest rates to a level they see as appropriate for controlling inflation.
Market commentator Dennis Gartman makes an interesting point in this regard, suggesting while the injection of funds was the correct action the key will be how this additional liquidity is subsequently withdrawn from the market at the appropriate time. If these funds injected are allowed to remain in the system more or less permanently Gartman argues it would be a highly inflationary development, so gold would likely gain and the US dollar would likely come under further pressure.
Countering this, Danske Bank points out at present it is simply impossible to know whether the injections globally have been enough to stabilise the respective banking systems as there is no way of knowing just how much risk each bank has taken.
As a result, Danske sees scope for further action to be needed from central banks before the current crisis has fully run its course, so news of further capital injections and other policy decisions would certainly not surprise in coming weeks. The best approach in the bank’s view? Keep a cautious approach and focus on risk management.
