A decisive response

Fire fighting has become an integral part of the job spec for regulators. No sooner is one crisis addressed, another emergency has to be tackled. And the need for decisive, rapid responses has become critical since the failure of Lehman Brothers in September.

Confidence in banks was shot in October, with market participants openly wondering which firm would fail next. Libor rates were being set at record highs on an almost daily basis, credit default swaps for some financial institutions leapt into the thousands of basis points, while financial stocks were heavily sold.

In response, central banks pumped liquidity into the system and slashed interest rates. To boost confidence in the banking sector, governments across the globe revealed they would inject capital into financial institutions in return for equity stakes.

These measures have largely been successful - there is now widespread belief that governments will not allow a major financial institution to fail, and credit spreads have come down accordingly.

Worried about the effects of the credit squeeze spreading into the wider economy, many of the capital injections came with caveats. Chief among them was that banks should continue lending to small businesses and home owners - in the case of the UK, at 2007 levels.

That brings another problem straight to the top of the agenda: what happens when banks hit balance sheet limits? The traditional way of freeing balance sheets to enable further lending has been the asset-backed securities (ABS) market. But this market has been well and truly locked down.

It was collateralised debt obligations of subprime residential mortgage-backed securities that sparked the crisis. As a consequence, the packaging, tranching and selling on of asset-backed notes has been broadly demonised. Investors have shied away from ABSs as a result.

Recognising the importance of securitisation, the US Federal Reserve Board announced the creation of the Term Asset-Backed Securities Loan Facility to breathe life into the market. As part of this, the Federal Reserve Bank of New York will lend up to $200 billion on a non-recourse basis to holders of AAA rated ABSs backed by new and recently originated consumer loans and small business loans. That comes on top of a $100 billion package to buy the direct obligations of government-sponsored entities and $500 billion to buy mortgage-backed securities backed by Fannie Mae, Freddie Mac and Ginnie Mae.

Other regulators are believed to be contemplating similar responses, but they face a major test. If this latest initiative fails, the authorities will have to think of new ways to ensure banks are able to continue to extend credit to customers - not to mention risk manage this. A lot rests on this one initiative working and restoring confidence in the market.

- Nick Sawyer, Editor.