As this year progressed it was increasingly characterised by the ‘risk on, risk off’ approach taken by big investors, creating massive volatility in markets. As the year ends, it would appear that most of the investors have settled into a ‘risk off’ stance.
In fact it isn’t just big investors that have adopted a defensive posture but banks and individuals; the banks driven as much by necessity as caution and individuals by the still-recent memory of what happened to them in 2009.
It is a major issue for central banks, which have pumped record levels of liquidity into the system in the hope that it would be circulated and create some activity and growth. Instead, they have seen most of it parked in US Treasuries – banks are effectively paying the US government to keep their liquidity safe. There have been near-record inflows into US money market funds in recent months.
In Europe, the European Central Bank this week lent its banks €489 billion of three-year money only to see almost all of it returned as ECB deposits. Like the US banks, the Europeans are paying their central bank to protect their cash.
The general mood of deep risk-aversion is also reflected in a blow-out of interbank spreads to levels approaching those seen in 2009 as banks have again become wary of lending to each other, despite the record levels of cash being hoarded by banks around the world.
The degree of anxiety within the banking system is increasing. The US Federal Reserve’s quarterly survey of senior bank credit officers, released yesterday, found that the banks are reducing their exposures to, or tightening their credit terms for, hedge funds, real estate investment trusts, companies and other financial institutions. They are also tightening the terms of their securities lending.
The Fed described the survey results as "an apparent continuation and intensification of developments already in evidence in the last survey in September."
That increasing conservatism will be of concern to the US economic regulators, given that the US manufacturing and housing sectors are just starting to show some signs of life. A significant tightening of credit could abort a fragile US recovery.
While one of the drivers for the increasing caution amongst banks is nervousness about the wobbling eurozone and the increasing pressure Europe’s sovereign debt crisis is exerting on its banks, the tougher prudential regime that will progressively be imposed on banks globally over the rest of this decade is also a factor.
To meet the new requirements, banks will have to either raise trillions of dollars of new capital or shrink their balance sheets by trillions of dollars, or execute a combination of both. In the current environment, reducing new lending is a more palatable option than raising new capital, particularly when term funding markets are virtually closed.
In this market, the major banks have already throttled back on lending, albeit in an environment of weak demand for credit anyway (Private credit lifts in November, December 30). They are trying to hold lending growth to levels that can be funded by growth in their deposit bases in the knowledge that their key vulnerability is their continuing need to raise term funding offshore.
There is something of the order of $50 billion of Australian corporate debt maturing in 2012, with a relatively high proportion of it owed by the A-REIT sector. With bond markets malfunctioning and banks wary about their property exposures there could be a glitch or two in prospect there.
More generally, until some of the liquidity within the banking system starts circulating economic growth in the developed world will be anaemic, at best, and there is a risk that the intensifying levels of risk aversion will be self-fuelling and self-fulfilling. Credit crises create their own victims.
An obvious pre-condition for some level of confidence to re-emerge and the dial to be turned towards the ’risk on’ setting is for the eurozone to demonstrate that it has the capacity to manage its affairs without an implosion within the economy of one of its larger members.
So far it hasn’t shown any ability to devise a credible strategy, which doesn’t auger well for prospects for the global economy or, indeed, global financial stability, in 2012.