In an interview with Emerging Markets, Barclays president Bob Diamond said: The real questions are around liquidity, funding and the money markets. These are the critical issues which need to be resolved to repair the financial system. The key challenge remained how to reduce counterparty risk, he added.
Pimco co-CEO Mohamed El Erian echoed calls for restoring the functioning, or unclogging the pipes, of the short term funding complex. He suggested the creation of government backed clearing houses for the interbank lending market. Restoring payments and settlement market, having the Fed encourage a restoration of counterparty trust, is now crucial, he said. [US authorities] can do that through exchanges, through guarantees, but you need to do something to restore trust between counterparties on Wall Street.
Former Federal Reserve vice chairman Alan Blinder told Emerging Markets that Western governments must act to guarantee interbank lending rates on a coordinated basis, to stem the credit crisis.
The US has the legal authority to do this and should, William Isaac, former head of the US Federal Deposit Insurance Coporation told Emerging Markets. Then other countries will follow.
Sky-high interbank rates have imposed high premiums for corporate and private loans, raising the risk of seizure in the US corporate sector as firms find themselves unable to roll over their debt. Three-month dollar loans between US banks carry an interbank lending rate of 4.82%, compared with the Federal Reserve reference rate of 1.50%.
Blinder nevertheless drew attention to the dilemma facing regulators in extending public guarantees to the so-called shadow banking system, including non-bank financial institutions, structured investment vehicles, conduits and money market funds that have to date relied on massive short term funding.
If you guarantee interbank lending, the next day you will see Western money market funds, commercial paper and so forth asking for support so there will be a startling pool of money that needs to be insured.
Equity markets this week shrugged off drastic interventions by global authorities, including coordinated interest-rate cuts by major central banks around the world, individual liquidity injections, a $700 billion U.S. bailout plan, and government plans in Europe to take equity stakes in banks.
Blinder noted that in the current phase of systematic deleveraging and collapsing asset prices you cant tell the difference between insolvent and illiquid institutions.
He said divergent regulatory responses in European countries, such as Ireland, to guaranteeing bank deposits set a dangerous precedent. His views were echoed by EU economic and monetary affairs commissioner Joaquin Almunia, who yesterday criticised member states for taking unilateral action to shore up their financial system, saying it had had a negative impact.
Diamond at Barclays added that it would be nice to see the European countries working together rather than reverting to a state by state approach.
On both the interest rate side and the liquidity side we need to know that our regulators are working together, he said.
US stock markets this weeksuffered their worst crash in history.