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Let me be clear up front in saying that I am not a supporter of the bail out. Bailing out any industry creates perverse incentives which remain well after the immediate effect of the bailout goes away.
Having said that, your comments are partially right but somewhat misleading. In fact , there is a limited liquidity impact in overnight funding. As you point out, bank to bank leading is predicated confidence that tomorrow the money you lent tonite is returned. Historically, and currently banks us credit ratings to price and place money with other countreparties overnight. Today, well credit rated banks still can access funds from other banks overnight, however at higher rates than historically available. The pricing signal at least still works. But borrowing by banks, especially in the case of smaller less sophisticated banks, in not always overnight.
We should understand that borrowing can be on either a fixed or floating rate basis. Remember the ARMs type mortgages that were at the center of many failed mortgages? That is floating rate borrowing. Banks incur little risk in offering these because they can fund them through deposits. assuming they have sufficient deposits. But suppose a bank wants to lend for a longer term - say for a car loan of 3 years. Any bank which lends on a fixed basis for any period of time incurs risk in that the tenor of the deposits don't match the tenor of the lending.
Is this an issue? Our last major banking crisis, the S&L debacle, was in part due to banks borrowing short term and lending long term. This is prepayment or convexity risk. It is particularly prevelent in the home loan market where when rates drop there is a high incentive for homeowner to refinance. To offset this banks must either borrow for longer terms or use derivative to swap this risk from floating to fixed. Ether transaction results in longer maturity credit risk for both institutions and, given current market condition, are either priced exceedingly high or not available. The problem for most banks, and by extention the corporates who borrow from these banks for capital projects and other longer term investments, is not funding overnight. I would point out that this issue has been building in the markets for the past 8-10 months.
I'm not sure of the benefit in agruements that there isn't a problem. Speak to any banker or the CFO of any business looking to raise funds and the lack of credit is clear. These arguements simply fail in the reality of the situation. I most certainly agree that what is being done is at best a ill designed short term fix and will certainly cause more problems in the long term. But lets focus on that. Put another way, the arguement shouldn't be if the patient is sick but rather that putting leeches on him isn't the best cure.
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