Ten years after the 1997-98 Asian banking crisis Western authorities have only now understood the gravity of the 2007-8 Western banking crisis. Policy has been reactive and reluctant, and politics have trumped efficiency and common sense.
In a rapid deleveraging process where confidence in the financial system has been broken, the multiple displays of policy confusion, reversals and wrong priorities have severely worsened the outlook for the global economy in the last several weeks.
Time is of the essence. It is critical to stop the dithering and present and united and decisive front, once and for all.
There is no excuse. The best practices are well known, they have been applied successfully in the past, and there are thousands of pages of literature for politicians to read and learn (among them the excellent IMF Occasional Paper “Financial Sector Crisis and Restructuring: Lessons from Asia,”). Unfortunately, they have been ignored.
There are three steps that must be applied quickly and decisively:
- Close the bad or small banks;
- Recapitalize the good or too big to fail banks; and
- Remove the bad assets from the system so that banks can return to the business of lending and restore the vital flow to the economy.
In addition, and to ensure confidence in the system while the restructuring and failures take place:
- Adopt a blanket deposit guarantee before proceeding with the major actions, with some conditionality attached to ensure banks right themselves.
And, above all:
- Present a coherent policy line that can be understood easily by citizens and market participants.
The list of policy mistakes is by now long but it is not time for recrimination.
The UK has today led the way with a package that matches the best practices, with guarantees, capital injections, removal of bad assets, and conditionality, and a global, concerted action should follow. A temporary global guarantee on interbank lending should be a priority.
The EU should stop the sad political show and prepare a package similar to the UK at the EU level. There is no reason why the EU can’t create a fund that is endowed by individual countries and can be used to restore the confidence of the European banking system – and the EIB is ready for this mission if needed.
Many banks are too big to be rescued at the national level but no bank is too big to rescue at the European level. European leaders have stubbornly refused to put in place a crisis management framework over the years; they want the benefit of a pan-European financial system without the cost. Now is the time to set apart old national issues and act for the sake of financial stability.
The US has the TARP at its disposal, and must start using it as soon as possible. Capital injections are badly needed at many banks, and MBSs can be purchased at any time. Central banks need to ease policy aggressively to ease funding conditions and restore confidence in the economic outlook. With the system in a liquidity trap, liquidity injections no longer work.
A final advice to policy markers. Please don’t over-regulate.
The temptation to fight the last war will be strong. This crisis has mostly been the result of badly applied regulation, not of bad or lack of regulation. This crisis was created by regulated institutions: banks and insurers were allowed to boost their leverage in a procyclical fashion and with very poor risk management systems. Supervisors allowed the expansion of off balance sheet activities. Best practices like Spain’s statistical provisioning were ignored. Please focus on improving the incentive structure and don’t engage in populist scapegoating, which will only hamper the healing process.
Banks and insurance companies must choose whether they want to be banks and insurers or investment companies. Limit their leverage and gross positions so that they are forced to choose and enforce sound risk management practices. Convince the accountants and adopt statistical provisioning, easier to apply and better for governance than higher or time varying capital ratios. And the EU must, once and for all, create a European supervisory body that has authority over and comprehensive information about systemically important banks.