Credit turmoil set to benefit big banks

Saskia Scholtes
Financial Times
Wednesday September 19, 2007

Large banks with big balance sheets and access to central bank liquidity could be poised to benefit from the recent turmoil in financial markets, says ratings agency Moody’s in a report on Wednesday.

As the crisis of confidence in credit has reduced access to cheap capital markets funding for non-bank participants such as hedge funds, the ratings agency argues that banks are set to play an increasingly important role as the much-needed distributors of central bank liquidity.

“Banks play a pivotal role, as they stand between the central bank and the rest of the financial system – the franchised distributors of the central bank’s vital product,” says Christopher Mahoney, vice-chairman at Moody’s.

The comment comes as international policymakers and regulators engage in increasingly heated debate over their response to the recent market turbulence, and whether banks should be granted a freer hand to allocate and distribute capital during times of stress.

Mr Mahoney says that the pace of financial innovation and liberalisation of capital markets in recent years has meant that banks have become distributors rather than holders of risk.

That process and change of function has increased the number of non-bank participants in the capital markets and is unlikely to reverse, he says.

However, the recent financial market turbulence has highlighted the fragility of such a system. This new type of fragility is in part because direct access to central bank liquidity is unavailable for non-banks.

In a such a system, the weakest link is confidence, says Mr Mahoney, stressing that confidence is a “state of mind” which is challenging for financial authorities to fix.

“The difficulty is that while [central banks] are able to fend off liquidity stress for banks, buttressing confidence in non-bank counterparty risk is more difficult, and restoring “fluidity” throughout the non-bank financial system will be even more complicated.”

As a result, large banks remain central to a systemic risk resolution, he says.

However, Mr Mahoney warns that solidifying the banks’ position will not necessarily alleviate the credit pain flowing through the financial system.

This is because placing greater emphasis on the role of banks will inevitably imply some deleveraging, which is bad for asset prices.

“The greater the degree to which markets reject various structured technologies and force assets on to banks or the auction block, the lower the prices will be for the assets held in such structures,” says Mr Mahoney.

That could force investors to recognise large losses, he says, with implications for financial regulation.