REINTERMEDIATION & THE CREDIT SLOWDOWN
[Latest Global Dollar Liquidity Measure: +13.4% annual growth rate; latest Endogenous Liquidity Index: -29.1%]

I don't pretend to know a whole lot about the analytics of Special Investment Vehicles (SIVs), Asset Backed Commercial Paper (ABCP) and Basel II. My numbers, however, show that the likelihood of a significant, protracted and global credit contraction continues to increase. Thus I was intrigued by two pieces that dwell on the impact of "re-intermediation" on the availability and cost of credit. Reintermediation is an euphemism for the absorption of conduits and SIVs into commercial banks' balance sheets (*). Thus Morgan Stanley's Richard Berner writes:

Reintermediation promotes a pro-cyclical credit contraction in three ways. First, credit concerns triggered liquidity backstops for conduits and SIVs, forcing a shift from a funding source that requires no capital to one that does. Inherently, that reduces leverage in the financial system. Second, in classic, pro-cyclical fashion, banks are raising the cost of new liquidity and credit facilities. Finally, and more controversial in terms of the analysis, courtesy of the move to Basel II, this shift to put riskier assets on bank balance sheets will boost future capital requirements for some European banks.

David Malpass, the usually bullish Bear, Stearns economist, expresses a similar opinion:

Bank balance sheets are expanding in connection with LBOs, SIVs, asset-backed commercial paper, and the breakdown in the securitization process (through which underwriters could sell their exposure). As banks make room for the new exposure, we expect tightness in other areas of their balance sheets, one of the disruptions facing economic growth.

(*) The arguments presented are based on Charles Goodhart. "Capital, not liquidity, is the problem", Financial Times (September 14): "... in the longer term the underlying problem will become capital availability, not funding problems and certainly not cash liquidity. Worsening risk raises capital adequacy requirements, and lower profits and higher write-offs reduce the capital base. The Basel II framework for regulating banks’ risk capital will raise the sensitivity of capital adequacy ratios to risk. When it is introduced in Europe at the start of 2008, many banks will find their prior cushions of capital, above the required limit, eroding fast. That could extend and amplify the crisis". See also William Chambers: "Basel II requirements will strenghten the financial system", Financial Times (September 18).