Financial Crisis and Rescue Package, plus Black Monday, Lead to Strange Twist

Yes, there have been enormous nominal losses from the turmoil on stock markets over this past week. With each equity sale, however, someone has walked away with a cheque. That cheque has been been made out for less value than once expected, but it is a cheque nonetheless. Where are the cheques going? They are being deposited in savings accounts and Guaranteed Investment Certificates with the commercial banks.

As a result of the flight to security, the commercial banks are reaping a bonanza in cash deposits. Furthermore, they are paying very little interest on such amounts. In fact, in many cases, there may be a double benefit to the banks from the stock market activity. The purchase transactions, even in these times of credit crunch, involve a good deal of borrowing on the part of credit-worthy buyers.

The banks want to send their extra deposit money out into the general economy in the form of loans. Banks historically make their highest profits during times of falling interest rates. They borrow short from depositors at low (and falling) interest rates and lend long at locked-in higher rates.

The influx of cash into deposit accounts is helping to keep short-term rates exceptionally low. Furthermore, the bias of central bank interest-rate policy is currently downward, in order to provide stimulus for the economy. But on the long side, bank lending to other institutions and businesses has become too risky a proposition. Hence, the credit crunch.

The following question is being asked by commentators on the nightly newscasts, “What guarantee is there that if the U.S. financial bailout package is passed by Congress, banks will start lending again?” Partly flowing from the set of circumstances outlined above, there are a number of reasons that a return to more vibrant financial markets is likely.

(1) For starters, a big portion of the competition has disappeared. There is little left of the investment banking sector anymore and the few that remain will be allowed to accept deposits. This was the segment of the market that got into the most trouble through complicated debt instruments and derivatives. The commercial banks have more of the overall lending field to themselves.

(2) The investment banks had the weakest capitialization, relying on short-term loans to finance longer-term operations. The commercial banking sector has much stronger capitalization thanks to its depositor base. That base of deposits has grown even stronger due to customers wanting to park their cash in safer investments.

(3) The commercial banks already have an opportunity to lend funds out at high rates of interest. They are not doing so because of worries about loan defaults due to bad debt on the books of potential borrowers. If it makes its way through the House, the financial rescue/bailout package will help to alleviate this concern.

(4) The commercial banks would love to “seed” their depositor money (on which they are paying low interest rates) into the general economy where they can make higher rates. The potential for large profit gains is enormous.

(5) There are a number of financially strong commercial banks with the potential to engage in merger and acquisition activity. Canada’s banks are a case in point. They still stand solid when it comes to reliability. Some of them are scoping out takeover targets internationally.

(6) Encouragement in the form of a sound financial footing for the whole sector would offer another strong benefit. More takeovers would be a positive step in improving the capitalization of relatively weaker banks and financial institutions. Sovereign wealth funds and private equity funds are other sources of additional capital infusions. Warren Buffet’s Berkshire Hathaway is already demonstrating confidence in the financial sector through its investments in Goldman Sachs and General Electric.

(7) Finally, with respect to the economy as whole, mergers and acquisitions in the banking community offer the potential for significant productivity gains. The Canadian government should allow banking mergers within the top firms in this country. This would build on our strengths and permit our financial sector to compete more seriously on a global scale.

Alex Carrick

Find Canadian construction-related economic articles in Canadian Construction Market News and in the Economic Outlook section of Daily Commercial News.

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