Jan 25/08
It’s All About the Banks
The armchair central bankers are out in force, and Ben Bernanke must be taking some comfort from the fact
that the complaints are coming from both the doves and the hawks. There are those saying “too little, too
late”, and those saying that the Fed was head-faked into an overly aggressive move by a one-day equity selloff.
But when it comes right down to it, even if the Fed moved a few days earlier than it might have, whether it’s
the economy, interest rates or the stock market itself, it’s all about the banks, mostly but not exclusively in the
US. What’s front and centre is the ability of the world’s banking sector to absorb some major punches from
writedowns (which now threaten to go beyond subprime mortgages), while at the same time, take on the
additional role as a credit supplier for activities that used to be funded through securitized, off-balance sheet
vehicles.
For the US economy, and by extension that of Canada, the risks are that if banks were left to their own
devices, they would be unable to meet these simultaneous challenges, and still maintain their required capital
ratios, without paring back their lending operations. Such a credit contraction could swamp the creditexpanding
impacts associated with a mild dose of Fed or Bank of Canada rate cuts, leaving the broad
economy, and non-financial equities, in peril.
That’s why, even if Monday’s equity meltdown triggered an early gift, we were inevitably headed for a faster
dose of rate cutting in both the US and Canada. The Fed could underscore that point by chopping another 50
bps next week, en route to a 2.5% funds rate in March. Rate cuts don’t directly ease capital constraints on
banks, but indirectly can be a key force in that direction. First, they help slow the erosion in housing prices, a
critical factor in pacing the losses on real-estate lending. They also provide a better backdrop for banks to issue
preferred or common shares to restore capital ratios, as we’ve
seen in a flood of such issues in recent weeks.
While we see the Fed as on track to avoid the feared massive
credit contraction, with US house prices still falling, and credit
performance eroding, it’s going to be a couple of quarters
before Bernanke pulls out the “mission accomplished”
banner. US bank earnings reports will remain under the
microscope worldwide. The VIX ratio, a measure of implied
volatility on the S&P 500, has had three well defined peaks in
the last few quarters (Chart), each coming on reports from
banks or investment banks revealing fresh writedowns. Look
for another rocky week for global stocks come April, as
American banks return to the confession booth.
Avery Shenfeld
Senior Economist
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