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What About Banks?


Financial system in need of emergency operation.


The current focus is on reforming the financial system. This is like discussing lifestyle changes with a patient admitted to ER in full cardiac arrest. What is needed is the defibrillator paddles!

While the system will need to de-leverage over time, it is imperative that immediate steps be taken to restore functioning of banks and the supply of credit.

The first step is to establish certainty - the holdings and values of risky assets held by banks and investment banks must be accurately determined. The need for greater certainty of values applies to sub-prime securities and leveraged loans as well as other risky assets. Without certainty about what is held by whom and their values, it will be difficult to restore confidence in financial markets.

Risky assets must be valued on a hold-to-maturity basis (in absence of clear trading intent) at 100% (the security will pay back) or 0% (the security will not pay back). Mark-to-market accounting should be suspended reducing volatility in asset values, earnings and capital.

In the aftermath of the 1997-1998 Asian crisis, unfashionable insolvency practitioners, employed by the IMF, established asset values for distressed Asian banks in this precise way.

Market values (based on increasingly unreliable or meaningless indices or quotes) or model based prices (to 16 decimal places) should be abandoned. There is no market for many risky assets currently. The models have not performed and are what got us here in the first place.

Once the true positions are known, then the capital levels that banks must hold against these assets can be set.

Capital levels should be set on a bank-by-bank basis by regulators rather than based on an inflexible formula that is frequently gamed by banks. Capital requirements should be eased, where appropriate. A "desired" long-term capital ratio for banks should be set. Banks should be allowed to transition to these levels over time. If all asset positions are known with clarity and confidence, banks can operate with lower than the normal capital requirements for a period.

Proposals to accelerate Basel II or increase bank capital are ill considered in the present market conditions. The banking system needs significant amounts of capital to cover losses. It also needs additional capital to cover assets returning onto balance sheet. Increased capital ratios would accelerate the de-leveraging already under way worsening the contraction in economic activity.

The final step is a government guarantee of all major bank liabilities. The step is not as radical as it appears. The Federal Reserve (for example, in the case of Bear Stearns (BSC) and JPMorgan (JPM)), the Bank of England (Northern Rock and the Special Liquidity Scheme ("SLS")) and Germany (the Landesbanks) have de facto already done this.

Term lending through the support facilities means that the central bank is doing more than providing liquidity. The central banks are underwriting the solvency of banks. If at maturity, the bank can not repay the advance, the central bank will be forced to continue to fund the borrowing bank to avoid triggering default. Bank's generally fail due to liquidity risk. It is sobering to consider that Bear Stearns was technically solvent when a withdrawal of liquidity brought it to the brink of a bankruptcy.

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An explicit guarantee has many advantages. It avoids inflationary money supply expansion and the need for money market sterilization operations. It would directly help restore confidence in banks and in the inter-bank market.

The Central Bank would charge explicitly for the guarantee based on the underlying risk. In this way, the taxpayer is properly compensated for the risk assumed. Central banks currently are providing a similar underwriting of financial risk at money market rates. This contrasts with the high costs being paid by banks on their equity capital raisings. For example, banks are paying 7% to 11% on hybrid capital raisings. Similarly, bank equity offerings are at substantial discounts to already low stock prices.

The proposed actions are contrary to free market orthodoxy and raise familiar concerns about moral hazard and rewarding greed. There seems to be no choice. There will be a high price to be paid but that will come later. As Charles Kindleberger noted in his history of financial crisis: "today wins over tomorrow".

Implementation of the three steps outlined above allows monetary policy, interest rates and fiscal policy to be directed to ameliorate any economic slowdown. Falls in asset values can be sustained where the borrower has sufficient income and cash flow to service the debt. Initiatives in the US mortgage market to help those with salvageable debt positions to avoid foreclosure are also valuable in this regard. Attempts by governments in the USA and England to maintain supply of "normal" housing finance are also targeted at this objective.

The defibrillator shocks must be accompanied by far reaching and fundamental changes in financial architecture and global capital flows. Regulation of banks, capital regimes, risk transfer, asset valuation, risk management, use of collateral, counterparty risk, model risk, rating agencies and financial accounting need radical surgery. Fundamental economic imbalances - excessive reliance on US consumption and excessive savings by other nations – must be addressed.

Resolution of the crisis requires brave and decisive steps that transcend geography, jurisdiction, regulatory silos, nationalism and rigid economic formalism. John Maynard Keynes knew the problem well: "the difficulty lies not so much in developing new ideas as in escaping from old ones". But as John Kenneth Galbraith observed: "faced with the choice between changing one's mind and proving there is no need to do so, almost everyone gets busy on the proof."

No positions in stocks mentioned.

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