The Hindu Business Line : Confidence-building across the globe

Countries impacted by the US financial crisis have been pumping liquidity into beleaguered banks and financial firms, reducing interest rates and attempting to shore up confidence in the banking system.

Bhavana Acharya

Much has been written about the US sub-prime crisis, the failure of big investment banks and how that led to a tightening of liquidity and credit in the global banking system.But what are governments and the central banks doing to address this crisis? Well, they have been pumping liquidity into beleaguered banks and financial firms, reducing interest rates and attempting to shore up confidence in the banking system. As the Indian government and the RBI embark on the same path of confidence building, we may see similar moves in India too. Here is a look at the key measures that various countries have adopted and how they help.

Interest rate cuts

Worries about the banking system’s exposure to problem US assets have dogged the financial world; most countries are witnessing a severe liquidity crunch, as financial markets are suddenly short of funds and banks are unwilling to lend even the funds they do possess. In response to this, many central banks around the world have opted to slash their interest rates. The US Fed has cut rates to 1 per cent from 5.25; UK rates are at 3 per cent, the lowest since 1955, Japan cut rates from 0.5 per cent to 0.3, lowest among major economies. South Korea made its biggest cut of a percentage point to 4 per cent.

India too has followed suit, slashing interest rates from 9 per cent to its present 7.5, in addition to a cut in the Cash Reserve Ratio to 5.5 per cent from 6 per cent (earlier at 9 per cent). Another boost comes from a relaxation in the amount banks are required to keep in government securities by a percentage point.

Lending rate cuts are expected to make borrowings cheaper, encouraging banks to start lending more to each other and also to corporates. Moreover, retail lending rates could reflect reductions stimulating consumption of goods such as cars and homes. Economists, however, fear that excessive cutting of interest rates now will depress rates to an extent where they cannot be used as a tool to stimulate economies in future.

Guarantees on loans

One of the key worries about the credit crisis was that it would lead to a loss of confidence in the banking system, both for players within it and depositors. Central banks have responded to these fears by encouraging inter-bank lending, by stepping in first to guarantee these loans. Australia will guarantee eligible wholesale borrowings in return for a fee to safeguard taxpayers’ interests similar to a move by Sweden to use $191 billion in guaranteeing new borrowings also for a fee. South Korea will guarantee foreign exchange dealings of domestic banks with international banks until June 2009.

The financial crisis kicked off on the back of defaults by borrowers, and the consequent erosion in the value of billions of mortgage-backed securities. Doubt has been cast on the ability of banks to repay loans as result of this deterioration in asset quality. With government support through guarantees, the reluctance on part of the banks to disburse loans could be addressed.

Guarantees on bank deposits

However strong its balance sheet or capital base, no bank can easily weather a run on its assets where all depositors simultaneously clamour for their money. An assurance of safety of deposits held will go a long way in easing poor confidence among deposit holders and calming investor fears.

Ireland was the first to guarantee all deposits, bonds and debts in six main banks for two years. The US increased the limit of insuring bank deposits, from $1,00,000 to $2,50,000 till December 31, 2009; Russia up to $26,000. Most European governments too have guarantees of varying proportions. Indian deposit guarantees are capped at Rs 100,000 under the Deposit Insurance and Credit Guarantee Corporation .

Boosting bank balance sheets

Lack of adequate capital with banks hinders liquidity and ability to lend. Therefore, central bankers have worked on the premise that an injection of capital into banks will improve balance sheets, restore capital adequacy and provide stability. The stakes so bought will eventually be sold to private players, it is hoped, at a profit.

The UK has pledged £37 billion to purchase preference shares in major banks; Germany will make available 80 billion euros for recapitalisation, while France promises 40 billion and Greece 5 billion euros . The US can inject $250 billion and purchase troubled mortgage assets from financial institutions as a part of its $700 billion package.

IMF funding

Not all countries have the ability to make it through the crisis unaided or pump unlimited liquidity into their banking system. In these cases, the International Monetary Fund (IMF) may step in and provide emergency funding. Ukraine receives $16.4 billion under a 24 month Stand-by Agreement economic programme.

Simlilarly, Hungary receives $15.7 billion while Iceland gets an emergency funding of $2.1 billion.

Additionally, the IMF has devised a Short Term Liquidity Facility (SLF) to help those emerging markets that have sound economic policies deal with the crisis. Conditions on loan approval are limited to measures considered essential to survive the crisis . It is designed to be easy to use and quick to push through. An eligible country can avail an amount up to 500 times its quota in the IMF with a three-month maturity period, and can draw the amount a maximum of three times in a year.

The banking system in India, being well regulated, is equipped to weather the financial storm, albeit with some support. The interest rate cuts came at a time when inter bank lending rates were escalating and money supply tight. Retail rates too have dropped; indicating a step-up in consumption and consequently, production.

Measures such as capital infusion may not be required unless regulators increase capital adequacy requirements as the vast majority of banks have capital adequacy above stipulated norms.