Household spending in most western markets have tightened and the investment climate for the corporate sector has deteriorated.
Stresses in global financial and credit markets are still very much apparent. Global wholesale funding market dislocation over the last few months has improved marginally, reflecting central bank initiatives including the provision for longer term facilities through the swapping of liquid assets for high quality but presently illiquid collateral.
Despite some improvement in wholesale funding markets, funding costs for banks are still substantially above the pre credit-crunch period and as such remain elevated. Continued stresses in the funding markets, combined with the need to reduce balance sheet exposures to risk in order to help maintain adequate capital positions, have been reflected in a significant tightening in credit supply by banks in important global markets such as the US, UK and the Euro zone. Either the refusal of credit or a higher risk premium has been charged. This is occurring in all loan segments from retail mortgages to SME lending to corporate facilities.
Mortgage approvals have fallen significantly, placing further pressure on property markets through falling prices and, indirectly, leading to higher loan defaults and repossessions. The recent and prospective acceleration in inflation will impact real household income growth. Combined with the tightened credit supply, this will weaken household spending growth.
Obtaining corporate loans has become more difficult and expensive. Business investment growth is easing, reflecting weakening demand and a cautious approach as the global economy tightens. Lower property prices also weigh on both business and residential investment.
An important issue for monetary policy in major markets is how the continued financial and market dislocation affects both asset prices and the availability and price of credit to both households and businesses.
Important market bank pricing benchmarks, such as Libor, and its associated implied pricing going forward currently show mixed signals. The heightened level of three month Libor implied volatility, derived from the prices of options traded, indicates considerable uncertainty about the outlook for short-term interest rates.
Part of the volatility reflects uncertainty about the future direction of policy rates. However, a large proportion of the volatility reflects uncertainty about the future spread between expected policy rates and the rates that banks charge to each other.
Term interbank spreads have fallen slightly since the high levels reached a few months back but remain high and volatile. Since the beginning of the financial crisis, banks to a large extent have ignored reductions in key central bank rates and have maintained or even increased their own lending rates to customers.
The deterioration in financial markets has led to strains in money markets. Banks and other market intermediators such as money market mutual funds, remain reluctant to provide term funding. This is reflected in the spreads between expected future policy rates and the rates that banks charge to each other, such as three month Libor. These spreads have widened over the course of the year in the UK, the US and the Euro area.
Credit default swap premia for banks and securities houses, which provide a measure of the cost of insuring against default, rose sharply in the first quarter of the year. They have also fallen back but remain higher than the long term average and particularly so against pre-crisis levels. Moreover, they are likely to remain high until a line is clearly drawn under the amount of credit losses and write-downs.
Credit conditions are crucial for the future direction and growth prospects of the global economy. Banks play a pivotal role in the economy by channelling the flow of funds from savers to borrowers. The financial crisis has severely interrupted this flow. A number of factors have restricted the supply of credit to businesses and households in western markets. Factors include the availability and cost of banks’ sources of funding, the deterioration of banks’ capital adequacy ratios due to asset write-downs and through the growth of balance sheet assets due to any new loan expansion, and changes in the perceived riskiness of lending to companies and households.
Banks fund their lending activities through both retail, such as customer deposits, and wholesale markets. Wholesale markets involve a variety of sources, including unsecured wholesale deposits, loan syndications, and securitisation (the packaging and selling on of existing loans). In the first half of 2007, approximately one third of net lending was being funded through securitisation in the dominant western markets. This has dropped substantially. Since the beginning of the credit crunch one year ago, the primary securitised debt market has been effectively closed and wholesale funding rates have increased relative to Central Bank market yardsticks.
If the securitisation market were to remain closed then that would continue to affect funding for new lending and would also require banks with maturing mortgage-backed securities to find alternative sources to fund existing loans. Some banks have looked to fund their increasing loan portfolios through garnering retail deposits.
Banks can answer balance sheet pressures through various ways. Management can issue new capital or retain more earnings. Alternatively, they can reduce the amount of riskiness of the lending they carry out, or dispose of assets. Many banks have scaled back their new lending. As well as increasing interest rate spreads, lenders have been reducing the availability of credit to borrowers. Going forward, at least in the short term, lenders are expected to reduce both secured and unsecured credit availability further. Lenders in western markets, and to a certain extent in other markets, have continued to raise their corporate lending rates.
With lending conditions set to tighten further, companies may look to the capital markets to raise funds for investment. However, corporate bond yields have risen noticeably although there has been little movement in the rate of high rated government bonds. This reflects the reappraisal of risk since the beginning of the credit crunch. Yields on investment grade bonds, which account for 90 per cent of global corporate bond issuance, have risen by around 50 basis points over the past three months and remain well above the long-term average.
Yields on non-investment grade bonds have also increased sharply, although they also have come back recently from year highs but remain high nonetheless. Finance raised through the capital markets has declined during the year and the higher cost of funds will likely to continue to restrict new net bond issuance.
In due course, but probably not until the latter part of 2009, global growth should reappear as policy stimulus packages already announced begin to make a real impact. However, the timing, speed and extent of the recovery will, to a large extent, be dependent on improvement in the wholesale funding markets for banks, specifically the access to and lower cost of funds which can then be on-lent to the corporate and consumer markets.