Wednesday, October 8, 2008

Martin Wolf: It is time for comprehensive rescues of financial systems

Wolf sees the rescue package as being global since the crisis itself is now global in its reach. Many of the policies he recommends are being carried out to some extent. It remains to be seen if this will be enough. I cannot see that the US bailout package can have much effect since it will not actually begin buying toxic assets until the new year! In this climate who knows what will happen by then.

It is time for comprehensive rescues of financial systems
By Martin WolfPublished: October 7 2008 19:13
, Financial Times
As John Maynard Keynes is alleged to have said: "When the factschange, I change my mind. What do you do, sir?" I have changed mymind, as the panic has grown. Investors and lenders have moved fromtrusting anybody to trusting nobody. The fear driving today'sbreakdown in financial markets is as exaggerated as the greed thatdrove the opposite behaviour a little while ago. But unjustified panicalso causes devastation. It must be halted, not next week, but rightnow.The time for a higgledy-piggledy, institution-by-institution andcountry-by-country approach is over. It took me a while – arguably,too long – to realise the full dangers. Maybe it was errors at the USTreasury, particularly the decision to let Lehman fail, that triggeredtoday's panic. So what should be done? In a word, "everything". Theaffected economies account for more than half of global output. Thismakes the crisis much the most significant since the 1930s.First of all, the panic must be dealt with. This has already persuadedsome governments to provide full or partial guarantees of liabilities.These guarantees distort competition. Once granted, however, theycannot be withdrawn until the crisis is over. So European countriesshould now offer a time-limited guarantee (maybe six months) of thebulk of the liabilities of systemically important institutions. In theUS, however, with its huge number of banks, such a guarantee isneither feasible nor necessary.This time-limited guarantee should encourage financial institutions tolend to one another. If it does not do so, central banks must lendfreely, even on an unsecured basis, to institutions too systemicallysignificant to be allowed to fail.By these means, the flow of credit should restart. But governmentscannot allow banks to gamble freely with the public sector's balancesheet. During the period of the guarantee, governments must exerciseclose oversight over the institutions they have decided to protect.The second priority is recapitalisation. The big lesson of the crisesof recent history – as an excellent chapter in the InternationalMonetary Fund's latest World Economic Outlook shows – is that"policymakers should force the early recognition of losses and takesteps to ensure that financial institutions are adequatelycapitalised".Recapitalisation is essential if institutions are to be deemedcreditworthy after the guarantees are withdrawn. Governments shouldinsist on a level of capitalisation that allows for furtherwrite-offs. They should then either underwrite a rights issue orpurchase preference shares. Either way, governments should expect tomake a profit on their investments when these institutions return tohealth, as they should do.Such recapitalisation is an alternative to forced debt-to-equityswaps. I do find the latter an attractive idea. Yet today it is sureto increase the hysteria, unless it can be made crediblyonce-and-for-all. Some will also note that my ideas are designed toavoid a shrinkage of the balance sheets of the core financial system.Some shrinkage of the financial system is inevitable, however,particularly in the US and UK. It should be allowed to occur in theso-called "shadow banking sector".This leads to a third question: what to do about the bad assets?Sometimes it makes sense to take such assets from the banks. That iswhat the new US "troubled asset relief programme" (Tarp) is designedto do. Because bad US assets are widely distributed across the world,the US programme to create a market for these assets – and perhapsraise their prices to a higher equilibrium level – will benefit manyother banking systems.Elsewhere, however, the quantity of bad locally generated assets seemssmall. Such schemes are then unnecessary. If banks are adequatelyrecapitalised such schemes are also redundant. Similarly, if banks areadequately capitalised, concerns about mark-to-market accounting areless important, since balance sheets can cope with the neededwrite-downs. But it may be sensible to state explicitly thatregulators will not focus only on current valuations in determiningthe capital requirements.The biggest question about these proposals is whether governments canafford them. Some economists argue that many banks are not only toobig to fail, but too big to save. They do so by pointing to ratios ofgross bank liabilities to host-country gross domestic product (seechart). But what matters is the ratio of worst-case fiscalrecapitalisation to GDP. Unfortunately, even this can be huge.Consider the UK, where the combined assets of the big five banks isfour times GDP. A recapitalisation equal to 1 per cent of their assetswould cost the government an increase in debt equal to 4 per cent ofGDP and a 5 per cent recapitalisation would cost 20 per cent of GDP.If any country's banking system started to suffer losses on such ascale, debt-to-equity swaps might become inescapable. They may now bethe only way forward for Iceland.Some argue that members of the eurozone have a special challenge:individually, after all, they have no access to a central bank. Theremarkable recent jumps in spreads between rates on German bunds andItalian bonds, to a peak of just under 90 basis points, suggests thatmarkets may agree. But inflation is also a form of default. A countrywith a central bank, such as the UK, may well suffer higher long-terminterest rates if doubt grows about its ability to finance needed bankrescues.Yet if a recapitalisation of a substantial number of eurozone bankswere needed, some member states might be unable to put up the money.There would be danger for the rest if that government chose either todo nothing or to initiate a debt-equity swap. Such actions might thenraise panic everywhere. Fiscal solidarity might prove inescapable. Inany case, co-ordination on how to proceed is essential if a healthyeurozone banking system is to re-emerge.This panic is also going to have a big impact on economies. So centralbanks,other than the Federal Reserve, should lower interest rates.Only last week I thought a half-percentage point cut in rates madesense for the UK. If I were on the monetary policy committee today, Iwould argue for a full percentage point. The world has changed,greatly for the worse.The finance ministers and central bank chiefs of the Group of Sevenleading high-income countries will soon convene in Washington. Foronce, these are the right people. They must travel with one task inmind: restoring confidence. History will judge their success. Thesepeople may go down as the authors of another great depression. It is adestiny they must now avoid, for all our sakes.martin.wolf@ft.com

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