Now, with the solvency of banks in question, could the credit crisis cause a run on banks?
*The Economist, August 16, 2007
“The new financial order is undergoing its harshest test. It will not be pretty, but it is necessary
THE lifeguards had been scanning the horizon for an oil-price shock, a bankrupt buy-out or a terrorist attack. But when the big wave struck last week it surprised them by coming from inside the financial system and threatening to swamp an unlikely shore, the money markets where banks lend to each other to help cover their daily operations. Investors have been asking for years if the frantic innovation in finance, especially the securitisation of just about every form of debt into a tradable asset, was a way to spread risk efficiently, or whether this left the financial system prone to rare—but cataclysmic—failures. It looks as if investors are about to find out.
Over the past week central banks have lent tens of billions of dollars to restore confidence to the markets. But it is already clear that this mess is about more than a bit of rash mortgage lending to Americans who were in the habit of falling behind with their monthly payments. Hedge funds and private-equity firms, kings of the boom, are nursing big losses. Debt markets that once handed out cash to all comers are tight or closed altogether. In almost every asset market, investors are scurrying to reprice risk—which mostly means to reduce it.
The gravest and most immediate threat is to the banking system. For the time being, banks no longer trust other banks enough to lend them money except on onerous terms; equally worryingly, they lack confidence that other banks will trust them if they want to borrow. It is alarming when the very outfits that exist to supply the economy with credit start to hoard it from each other. At best this tightens monetary policy; at worst, a shortage of cash will cripple the payments system and cause runs on otherwise solvent banks and businesses that cannot rapidly raise funds.”
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