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Market Sense

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Restoring faith

Tue, Sep 30 2008, 09:38 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

What should have been a day of hope turned into a day of desperation. We are facing a systemic crisis of confidence in the global financial system that is pushing us increasingly close to a complete meltdown. I thought the agreement on the TARP in the US would shore up confidence in the system and set us on the long and difficult road to recovery. Today’s market reaction however has been far worse than I expected, and signals a complete and widespread collapse in the confidence in the financial system. This crisis of confidence seems grossly out of proportion with the albeit fragile fundamentals of the financial system and of the global economy. But it is now threatening to turn into a self-fulfilling run on the system which could trigger a global financial and economic meltdown. I see two key triggers behind this confidence crisis: First, the fear that European policymakers are unprepared and unable to act in a structured and decisive way to rescue their financial system; Second, the fear of an adverse loop between a deteriorating growth environment and a brittle financial system. Policymakers need to escalate their response to address these two concerns. European policymakers should send a clear and loud signal that they stand ready to implement a European TARP or a similar systemic intervention to guarantee greater transparency and adequate capitalization in the financial system. This should ideally be accompanied by a surprise rate cut by the ECB, or at least by the recognition that inflation concerns have been put to rest, and that the bank is getting ready to ease policy. I realize this would be an extreme departure from the path followed so far; but the policymakers’ insistence that the problem would remain confined to the US smacked of a complacence which has now backfired, while the ECB’s unrelenting focus on inflation seems increasingly out of touch with reality. This global crisis needs a global response, and it needs it now—the alternative is giving up, and that is not an option.

The gravity of the situation cannot be over-emphasized, and the dangers should not be underestimated. What we are witnessing is a complete loss of faith in the entire financial system, on a scale and with an intensity wholly out of proportion with even the very serious problems that the system faces. In today’s trading, the share price of financial institutions have plunged across the board, regardless of their financing needs, their exposure to the real estate market, their holdings of toxic assets, their mix of commercial and investment banking activities. Meanwhile, money and interbank markets remain paralyzed, with market participants hoarding cash and financial institutions unwilling to lend to each other. This paralysis in turn is exacerbating funding difficulties, and if it continues will force financial institutions to dispose of liquid assets to generate cash, triggering a wave of sell-offs and price declines in otherwise perfectly healthy assets.

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Published on  Tue, Sep 30 2008, 09:42 GMT