The Credit Crisis
Many people are talking about the “Credit crisis”, the “Liquidity crisis” or the “Financial crisis”. However what is actually happening.
As discussed in the previous chapter, banks create liquidity. They do this by borrowing money in the short run and lending it for the long run. By doing this they absorb a certain risk. They run the risk that they cannot repay their short term obligations if they cannot find someone willing to refinance them. This risk increases as the funding gets shorter and the loans get longer. If a bank funds a ten year loan with ten year funding there is no (very little) risk for a bank. The bank knows that the ten year funding can be repaid after ten years from de cash flow received from the customer (given the customer pays). If the funding of the loan has a maturity of one year, the risk becomes rather large because the bank will need to refinance the loan ten times. Each of these ten times a bank might fail to raise funding. The risk of failing to raise capital and repay its creditors is the liquidity risk.
This risk was generally considered negligible. In history there were always people or companies ready to refinance a bank. However now this situation has changed. People are still willing to finance banks, but under an extra condition. Banks can currently only attract money for a very short period (up to 3 months). This means that the liquidity risk which banks are forced to run is very high right know. Banks have a lot of short term obligations (repayments in three months) but only long term assets (loans to customers for ten years). In other words, there is a lack of liquidity for banks. Furthermore banks are unable to increase their liquidity, because they cannot lend money for a longer time period. Thus the cure to the liquidity crisis will be long term lending to banks, but who will do this? Banks will not. They cannot afford to lend money to other banks for long periods because this will dramatically increase their own liquidity risk. Government guarantees will not change this. The credit risk is not relevant in this decision anymore (for banks). Even if a bank has a surplus of cash it cannot be lend to other banks for ten years, because the surplus can evaporate in three months.