Rosengren: Bank Restraint Could Spread Weakness

CHARLOTTE, N.C. — Boston Federal Reserve Bank president Eric Rosengren Friday expressed concern about the duration of the “illiquidity” in financial markets and warned that as banks repair their balance sheets by restraining lending, economic weakness is apt to spread beyond the housing finance sector.

Rosengren observed that banks have increased capital but suggested that they may still not have enough capital to absorb further credit losses. And he said that smaller banks, which have thus far been little affected by losses on complex, subprime mortgage-related credit instruments, could suffer if declines in residential and commercial real estate prices worsen.

Financial institutions and investors are “skittish” about entering into transactions with counterparties in which they lack confidence and are reluctant to borrow in the term funding market for fear of “signaling” trouble to other market participants, Rosengren said.

As measures of this skittishness, he pointed to the “unhinged” London Interbank Offering Rate and the heavy bidding at the Fed’s auctions of 28-day funds under its term auction facility, where he said there is less stigma attached to going to the TAF than to the regular discount window or to the private money markets.

Fed liquidity provisions through the TAF and other facilities have helped alleviate liquidity problems but are not a long-term solution, he suggested.

Rosengren focused his prepared remarks at the Richmond Fed’s annual credit market symposium on what he called signaling, by which he meant financial institutions’ “reluctance to provide a signal that might indicate weakness — which seems to have played a significant role in the behavior of many financial market participants of late.”

His basic premise was that “as firms have become increasingly concerned about the valuation (pricing) of certain assets, their ability to accurately assess counterparty risk and the liquidity position of counterparties has become clouded.”

“The lack of transparency in the prices of underlying assets, and the significant losses of some financial firms whose deteriorating situation had not been evident in earlier financial statements, have together made investors skittish,” he said.

“As a result, financial firms are increasingly willing to pass up the use of other attractive financing opportunities if they believe that action might lead to speculation about the liquidity or financial strength of their firm,” Rosengren said.

“While such skittishness is not unusual during periods of illiquidity, it is unusual for a period of illiquidity to last this long,” he added.

— Market News International

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