While most observers are transfixed on the dramatic plunge in the world’s stock markets, there are ominous signs unfolding in other parts of global finance. In one of the worst periods since Black Monday in October 1987, market observers have started uttering the phrase “total market capitulation” as assets were sold indiscriminately across all markets, with virtually no safe haven. Most worryingly, in the short-term funding markets, liquidity is beginning to fade, and banks are limiting use of their balance sheet. As a result, the Federal Reserve, the People’s Bank of China (PBOC) and Central Banks around the world pumped hundreds of billions of dollars of additional liquidity into the overnight lending market.
With lingering memories of the Great Financial Crisis (GFC), the Fed is trying to stem any future drying-up of credit, where institutions curb lending that induce a further slowdown in economic activity. Although the GFC was sparked by subprime mortgage-backed securities that went bust and spread to global institutions that owned these assets, in an interconnected world, a liquidity crunch turned into a full-blown crisis of confidence that could not be quickly stopped or easily rebuilt. Liquidity issues became solvency issues. But this time, the corporate sector is the culprit, highly-levered industries in particular may continue to be a source of instability. In the world’s second largest economy, the People’s Central Bank of China also moved swiftly and injected hundreds of billions of dollars via reverse repo operations to maintain liquidity in the markets. Most recently, it appears the Bank of Gansu (in Northern China), a troubled lender, will be thrown a lifeline by the government in the form of a significant capital infusion. Whatever the case may be, if these dislocations are not contained, it may spread to the banking sector, and once again liquidity will be at the heart of the matter.
After the financial crisis, much of the focus was on encouraging the too-big-to-fail financial institutions to adopt regulatory measures to better weather future financial stresses. And although China was spared the worst ravages of the 2008 Global Recession, it instituted macroprudential tools focusing on liquidity constraints to steel the banking sector against a financial meltdown. Prudential supervisory regimes from Dodd Frank to the Basel Framework targeted measures to improve market liquidity and mitigate short-term wholesale funding risk. Requirements such as –the LCR (liquidity coverage ratio to lower banks’ liquidity risks), reducing overreliance of borrowers in the repo market, and more conservative haircut marks for collateral pledged at institutions became key mechanisms for reducing systemic risk. Why such measures? Banks finance long-term and, at times, illiquid and risky assets (paper that is not easily traded and hard to value) with short-term, safe. and highly-liquid liabilities that can be recalled quickly and without notice (as in the case of deposits). Inherent in this arrangement is the maturity mismatch between short-term liabilities funding long-term assets. This one of the biggest sources of risk for a bank that treasury teams must adroitly manage. Over the last several years, financial institutions begrudgingly spent billions of dollars to hire consultants and other advisors to retrofit their organizations – to make enhancements to policies, improve operations, and introduce technology solutions to institutionalize a broad regulatory mandate.
Policymakers demanded that systemically important financial institutions, whether in America, Europe, or China, get a better read on the pulse of the organization, including accurate monitoring of their liquidity needs across the entire enterprise – legal entities, business lines, geographies – which is no easy feat. Accurate decomposition of sources of intraday liquidity, including reserve balances at the Central Bank, unencumbered assets on a bank’s balance sheet, lines of credit with other third-parties, and payments from other Large Value Payment Systems needed to be tallied. This was an expensive multi-year effort. But after implementing Dodd Frank and Basel, a case can be made that banks are better capitalized with stronger balance sheets and have a greater vigilance of their liquidity needs.
However, with the treasury market under duress and short-term credit drying up, treasury departments across the corporate world are scrambling for liquidity in a mad dash for cash. Whereas banks were the main of concern in 2008, today due to the market-wide coronavirus disruption, companies in economically-sensitive industries such as energy and consumer discretionary sectors – airlines, entertainment, and overall travel – are under severe strain and become involved in cash-grabbing when given the chance. Hundreds of Chinese companies are attempting to raise billions of dollars to stay afloat. Amongst the most vulnerable are smaller-sized firms hoping to be approved for low cost loans with favorable terms.
Globally, businesses of all sizes are examining options for raising liquidity, including drawing on lending facilities at banks, selling assets, tapping short-term bridge loans, and accessing other lines of available credit. These battered industry sectors have been the most active in requesting funding. The concern at banks is, what happens if companies from other industry sectors start doing the same thing? They already have. Numerous firms across the corporate world have begun their quest for additional liquidity, whether it is need or not. Boeing and Kraft Heinz are drawing on their credit lines, and other firms, such as Exxon Mobil, despite having one of the strongest balance sheets in corporate America, felt compelled to do the same. The sobering fact is that the full effect of the coronavirus is yet to be felt. What happens a few months from now when employees are laid off, companies are shut down, and firms can’t pay their bills and start missing payments? That may ultimately lead to a wave of credit rating downgrades and default. What starts as problem in the corporate credit markets could infect the banks and ultimately the entire banking system. This scenario is not limited to the U.S. but could conceivably play out in Europe, China, and elsewhere.
The coronavirus dislocation is also causing an increased demand for dollars around the world. For Chinese firms (e.g. airlines and real estate developers) that hold large amounts of dollar-denominated debt, rising debt service costs may become untenable. Some have suggested that the U.S. Fed may consider re-opening dollar swap lines with its global counterparts as it did during the Great Financial Crisis. But given how strained US – China relations have become, swap lines between the Fed and PBOC seem highly unlikely. A report by the Council on Foreign Relations argues that China's trillions of dollars in reserves gives it ample ability to meet the payment demand of dollar-based debt of its firms, if needed.
From liquidity concerns in the overnight repo market to a dollar funding squeeze, central banks may be called on yet again to prevent a global funding shortage. Expect to see more intervention from the Fed, the ECB, the People’s Bank of China, and other central banks to shore up global liquidity pools and, just as importantly, help maintain confidence in the markets.