Twin crises, banking and financial, not the same

The global economy is facing twin problems, a bank and a financial crisis. It is important to distinguish between the two because the policy prescriptions and the choices of where to invest will be based on which of these two issues dominate the financial world. First, we need to define the distinction because it is details which will be affecting our judgment.

A financial crisis occurs when there is a failure in capital markets. It is associated with savaging of assets prices because of credit defaults and will lead to restrictions in a firm’s ability to raise capital. The problems with CDO, default swaps, mortgages, commercial paper funding can all be lumped together as part of the financial crisis. The financial crisis means that markets cannot clear at fair value prices and a premium must be given to provide liquidity. The credit crunch arises from because the price of credit availability is higher than the expected return on projects.

A banking crisis is associated with the lending activities of banks. This could be interbank loans or loans to commercial enterprises. A banking crisis is also associated with the capital adequacy and solvency of banking institutions. It is a funding liquidity problem and a crisis that is associated with bank runs. There will be a flight to quality as investors move their money into the risk free assets and will not lend. Bank solvency is questions so money is moved out of any risky asset even overnight funding.

There is the freezing of money markets. Now the banking crisis can actually be manifested in the capital markets through the shadow banking system of money market funds. If money market funds will not lend, and there is a flight to quality into Treasuries, there will be a “seizing” or “freezing” of money markets. It is not a price effect but a quantity effect. There is no lending at any price. There is no liquidity or lending activity to speak of.

The banking and financial crisis may occur at the same time but it is necessary for them to both happen. They could also be classified as a liquidity and credit crisis. For a credit crisis, the appropriate policy is usually to lower rates. A credit crisis is mainly focused with the price of risk. The credit event is usually tied to the business cycle and a downturn in the quality of debt. In a banking or liquidity crisis, the price of credit is not the issue as much as the quantity of the credit. You have to get banks to lend their reserves. If there is no lending because banks believe other banks are at risk, there is a collapse in the credit markets.

The Fed thought it was dealing only with a credit or financial crisis emanating from the subprime housing market collapse. The appropriate action would be to allow pricing to adjust in the capital markets for those securities that were falling in value and lowering rates to ensure that there was no carry-over to other market sectors. Unfortunately, the financial crisis then became a banking crisis as it was believed that the subprime housing market losses were concentrated in banks which would erode their capital. In the banking crisis, the cost of credit is not important. The value is on the ability to shore up balance sheet and provide equity capital for banks and provide for the safety of deposits. It is this type of crisis that requires more active intervention and will take longer to solve.