To restore trust between the banks, an international exchange operated by the world's central banks should be set up through which all future interbank transactions would operate
THE GLOBAL banking system has been under severe stress for more than a year, largely due to a lack of trust and confidence among banks in each other.
This lack of confidence has resulted in many banks only being prepared to lend to each other on an overnight basis.
In turn, this makes it impossible for banks to provide the necessary funds to industry or the public, both of which need funds for much longer periods. However, if a bank cannot be fully confident that it will be able to get money in the future, then it cannot take the risk of lending the funds it has to customers.
To deal with these difficulties and to try to make funds available for industry and the public, governments have implemented a range of solutions, including guaranteeing the interbank market, guaranteeing all deposits, injecting capital and increasing capital ratios.
Injecting capital and promising to increase capital ratios have not worked because there is no certainty that the capital injections will be sufficient and the calls for increased capital ratios are an indirect way of implying that future performance will be poor and therefore there is an increased need for provisions.
Against an uncertain economic environment, that uncertainty cannot be eliminated by indirect means such as capital because no one can know how much is required.
Within reason, the limited term guarantees of deposits or the interbank market have been helpful. However, these are only temporary solutions and there can be no confidence that the same crisis will not reoccur when the guarantee period is up. In fact, in the absence of change, a crisis is highly likely to occur again.
Once confidence has been lost in the working of the banking system on one occasion, the system is by definition more fragile, as everyone knows it has broken down once and therefore can happen again. This clearly points to the need for a new structure.
The essence of the banking system is intermediating between the essentially short-term nature of deposits and the longer-term nature of loans.
In addition, the banking system acts as an intermediary between areas where there are surplus funds and areas where there is excess demand for funds.
The interbank market has evolved to deal with this intermediation.
However, this market has evolved largely on a self-regulated, principal-to-principal basis. It is an opaque market with participants only having limited historic information about each other.
To avoid the problems that have arisen in the past year, a new structure for the interbank market is required which instils confidence, is transparent to the regulators (at a minimum), and is fully controlled. In addition, regulation must be enhanced to focus on all exposures rather than operate in a world where exposures can be made to disappear by being taken off balance sheet.
It is proposed that the world's central banks establish an international monetary exchange (IMX) through which all future interbank transactions would go.
The IMX would operate as any normal exchange. The central banks would fully and unconditionally guarantee the exchange counterparty performance, so that no bank would have any reason not to supply funds to the exchange. Each central bank would be fully responsible for the liabilities to the exchange of the banks for which they are the primary regulator. The IMX would be owned and run by the central banks.
Depending on structures, each central bank's performance would be guaranteed by its government. However, in the worst case these guarantees could never be higher than the existing deposit guarantees.
The IMX would operate like any other exchange, with the critical benefit being that exchange participants could deal freely with the exchange without having to enquire about the credit status of other participating members. Exchange technology is well established and available from many vendors. An exchange could be established in a matter of months by adopting the proven technologies from established exchanges.
There should be an exchange for each major currency, initially establishing the global euro exchange (GEX), global dollar exchange (GDX), global yen exchange (GYX) and global sterling exchange (GSX).
These would be owned and run by the respective central banks for each currency. Each central bank would guarantee the performance of its relevant currency exchange and set rules for the institutions that are eligible to borrow from the exchange.
The current structure of the interbank market, coupled with the off-balance-sheet nature of many products, makes proper regulation of the financial system almost impossible.
The unregulated nature of interbank and derivative activity, together with the many off-balance-sheet products, has facilitated the largely uncontrolled growth of credit and provided no early warning system to central bankers on either a global or local basis.
The introduction of the exchange will provide central banks with the complete and instantaneous information required to regulate those banks they are standing over.
The inability of any institution to access the exchange without receiving the approval and meeting the requirements of the authorising central bank provides a formidable array of controls and information to the central banks.
Clearly those entities that are allowed to borrow from the exchange need to be prudently regulated and need to pay for the benefits of exchange membership.
Institutions which are members of the IMX should be charged for the access to funds that the scheme affords them. The unit cost of exchange participation could be set based on the standalone rating of the bank and the maturity of its net obligations, namely the degree to which it is a net borrower from the exchange.
Over time the exchange participation fees will establish a strong reserve fund so that the system becomes self-financing.
Irrespective of economic actions that are taken to stimulate the global economies, it is essential that structural change takes place in the global banking market to avoid a reoccurrence of the collapse in confidence and freezing of the banking market.
In the absence of such an exchange, it is unlikely that full confidence will be restored in the global banking system as today's problems could easily happen again.
The essence of banking is ensuring efficient use of funds for the benefit of industry and society, with a fully functioning interbank market being the cornerstone of that intermediation. However, the current interbank market is not working and is inefficient, opaque and largely unregulated.
Introducing a regulated exchange would: restore confidence; be more efficient by eliminating the multiparty nature of existing interbank activities; be more transparent, as all interbank and even derivative activity could be instantaneously and centrally recorded; and greatly enhance the regulatory power and information of the central banks as both the owners and controllers of the exchange.
Key features of the exchange
1. Anyone can offer liquidity to the exchange at a set price including the central banks.
2. All interbank lending of participating institutions must be transacted through the exchange.
3. Borrowing from the exchange shall be at the same price irrespective of the borrower, that price being set by the providers of liquidity to the exchange at any point in time.
4. Each central bank will set limits on local institutions and also charge them for use of the guarantee, see "controls" below.
The benefits of clearing interbank liquidity through a robust trusted exchange are:
1. Restores the necessary trust and confidence in interbank lending.
2. Allows for an innovative and free market.
3. Provides regulators and governments with consolidated real-time information on global liquidity flows and counterparty exposures, thereby helping prevent excesses before they occur.
4. Reduces redundancy in the system through interbank netting at the exchange level.
5. Significantly reduces counterparty management/friction costs. • Dermot Desmond is founder of private equity company International Investment and Underwriting