The need for a comprehensive and global solution

We are facing a global financial crisis and bold steps by policy makers gathering this week in Washington are urgently needed. It has become clear that the policy interventions to date have not restored confidence in markets. Rather, at times, by being ad-hoc, interventions have actually created more turmoil. A comprehensive and global approach is needed. It should address the core problems in the financial sector — lack of liquidity in markets, doubts about the value of troubled assets, and a clear shortage of capital – address the underlying losses (notably in housing markets), and cover all markets around the world.

What is the problem today? In a nutshell, lack of confidence. Financial institutions are unsure where the losses are. Even if a financial institution knows that its own balance sheet is intact, it cannot be sure that its counterparty is in the clear (or in some way exposed to a third party with problems). Underlying the lack of confidence is the problem of large losses in US and other countries’ housing markets, and the risk of economies spiralling down leading to massive corporate defaults. In this environment of distrust, uncertainty, and capital shortage, standard approaches will not suffice. What must be done?

• First, as some governments have concluded, the lack of confidence means that some explicit public guarantee of financial liabilities is almost unavoidable.

But make no mistake here, such guarantees just buy time and can be very costly for governments. Besides being temporary, such guarantees need to include safeguards against risk-taking, such as heightened supervision and limits on deposit rates offered, and be well coordinated in integrated markets such as the Eurozone.

• Second, in some markets, given the size of the problem and the difficulty in valuing assets, the state needs to take troubled assets off banks’ books and force the recognition of losses.

Asset purchases done transparently at fair market value would set a price floor and thus help clarify the value of financial institutions, opening up scope for recapitalisation.

• Third, more capital is needed in all types of financial institutions but especially in banks.

Clearly, private money is scarce in today’s environment and loss recognition alone may not induce any fresh injection of private capital. Many governments have already signalled support for their systemically important financial institutions. But governments should not just rescue defunct financial institutions, they should be pro-active in their support. As already announced in some markets, public capital on a large scale is needed. It should support those financial institutions that are systemically important and that have franchise value.

One strategy that has worked in past crises is to match new private capital subscriptions with state capital, which imposes a market test. And governments should be properly compensated for taking on this role and safeguard their interests with strict control rights.

• Fourth, much more international cooperation is needed.

Too many recent measures have been taken with largely national interests in mind, and not enough has been done to prevent the negative consequences for others, especially in Europe. Greater policy coordination will be the necessary starting point, but it will have to be backed up by concrete joint actions. A multilateral pool to support systemic banks with large cross-border activities can be such a mechanism to achieve this coherence.