21/05/2009

The Financial Crisis: Exit Strategies

 

The European Economic Forum held recently in Brussels underscored several welcome orientations in the management of the crisis which constitute, if implemented, a radical departure from past practices.

 

A first feature is the recognition that the agenda for “regulatory reform” should be pursued with vigorous determination immediately rather than wait for the turbulence created by the crisis to subside. Indeed, as the immediate pressure lessens, the sense of urgency might wane which, in turn, could lead to largely “sub-optimal” compromises that may not deliver the robust framework needed to ensure that the financial system will not be subject to similar crisis in the future.

 

The need for such an approach was unanimously recognised and was being translated into an ambitious action plan by the European Commission who will publish already on the 27th of May the main orientations it intends to submit in “legislative form” this coming autumn. These proposals are largely based on the recommendations formulated in the de Larosière Report and will constitute an important milestone in improving the regulatory architecture and oversight of financial markets.

 

The needle of the compass needs however to remain firmly pointed in the intended direction and it is hoped that the European Council, the European Parliament and the Member States will overcome narrow “national” priorities to deliver legislation that will benefit all European citizens. It should be clearly understood that a deepening of the crisis or a welcome “improvement” in economic conditions both entail the temptation of “protectionist” measures that must be avoided at all costs. In the case of further deterioration the danger lies in “active” protectionist measures, while under an improving scenario, the temptation will be for “passive” measures such as the failure to implement needed reforms.

 

The second feature is the early discussion of “exit strategies”. Nobody underestimates the difficulties of managing smoothly an exit from the current crisis. Recognizing that, early on in a recovery, monetary authorities and governments will need to take unpopular decisions in order to correct the accumulation of unavoidable (and appropriate) current budgetary deficits as well as the related bloated government indebtedness, is a first and important step.

 

But, though a key ingredient of ECB monetary policy has been to ensure that “price stability” is maintained over the medium term through careful monitoring of inflation expectations, it might be appropriate to broaden somewhat the focus of the ECB’s attention so as to manage “recovery” expectations, as they may be perceived by the citizen and markets at large. Indeed, the “feel good” sentiment induced by a recovery, especially if the crisis is drawn out, leads citizens to expect concrete improvements which put governments under strong pressure to deliver “unaffordable” benefits.

 

Putting aside an unproductive witch hunt for the responsibility of past excesses (we are all to a greater or lesser extent culprits), there is no escaping that we cannot recover from this crisis without paying the “price”. That means that the world will not revert to its pre-crisis state. Politics therefore should aim at managing the recovery in such a way as the “pain” is distributed as “fairly” as possible, though history tells us that it is always the most vulnerable that tend t be the worst affected.

 

In particular, a successful exit strategy will be tributary to correcting some of the structural imbalances that caused the problem in the first place. Two such imbalances are of particular relevance: the equilibrium between indebtedness and savings based on unsustainable accumulated borrowings by the United States and the corresponding excess of savings in the emerging market/oil producing countries on the one hand, and the excess leverage that has crept into world financial markets over the last two decades.

 

Finding a new equilibrium for the debt position of the United States must be, by nature, a long drawn out process: indeed, should the surplus countries fail to recycle their dollars brutally or should US consumers decide to rebuild savings to historical averages too rapidly, a major economic collapse would be unavoidable re-enacting the 1930’s depression scenario. Over the coming years, it is important to build up the domestic purchasing power of surplus countries allowing this demand to substitute progressively for US demand for goods and services.

 

With regard to correcting the excess leverage within the financial system, the situation is extremely complex: once again, unilateral de-leveraging by banks, financial institutions and consumers without compensating liquidity being injected by monetary authorities and fiscal stimuli would lead also to depression. However, government intervention can only compensate for part of the withdrawal of liquidity caused by the de-leveraging process. In addition, gauging the amount of de-leveraging needed depends to a large extent on the quality of assets that have been financed through debt instruments: clearly the minimum amount of de-leveraging must be in excess of the amount of “toxic assets” in the system, so as to restore a sufficient capital base. At the time of writing, there is, unfortunately no reliable evaluation of the amounts concerned.

 

Depending on the values one puts on these variables, the outcome leads either to deflation (the worst case) or to inflation (the second worse case) but it would be foolhardy to expect to manage “recovery” in such a way as one would fall neatly in between. Managing appropriately “recovery expectations” means therefore preparing public opinion to a slow drawn out process of recovery involving a dramatic rethink of economic policies with a greater emphasis on  social content. Though the undeniable benefits of a “market economy” should not be challenged, its excesses should, nevertheless, be firmly reigned in. 

 

There seems to be a fairly wide consensus that exiting from the crisis needs as a precondition the restoration to health of the banking sector. If a systemic melt down was avoided last October, it was due largely to the rapidity with which Central Banks and Governments intervened decisively. Several emblematic measures were taken under enormous pressure, which, even if they were coordinated, nevertheless resulted in a further fragmentation of the banking market as each national government instituted its own indispensable tailor made measures. These included: deposit insurance guarantees, interbank lending guarantees, and recapitalisation of banks under different national schemes as well as interest rate cuts accompanied by “quantitative easing measures”.

 

This “patchwork” of measures has undoubtedly complicated the restoration health of the banking sector, especially if one wishes to preserve a “level playing field” between competing institutions that act on a cross-border basis. The legislative initiatives being prepared by the European Commission attempts to address many of the problems created. Another important initiative has been the conduct of stress test exercises aimed at restoring of the confidence of banks between themselves but also of their customers.

 

One aspect that seems, so far, to have escaped detailed consideration is the question of managing the exit from the “temporary” government support for interbank lending which was implemented hastily last October. At the time I had suggested a centralised and uniform approach using the good offices of the EIB as a “clearing house” for interbank lending, with each Government counter-guaranteeing the solvency of its national banks (see article of 30/09/08: The Financial Crisis: How to structure a European initiative).  Though this idea may not have been practical in view of the urgency, it may useful to revisit the concept in a modified form as part of the measures aimed at restoring confidence in the banking system and allowing for the withdrawal of government and Central Bank support in an orderly manner.

 

What is being proposed is setting up of a “central clearing mechanism” for interbank lending. The operator could act under the aegis of the ECB. All interbank lending in € would be cleared through it allowing the daily “netting” of interbank positions for each participating institution. Netting would take place regardless of the “maturity” so that only a net debtor position would require posting of eligible collateral. Such a mechanism would drastically reduce the “gross volume” of counterparty risk (reducing the leverage in the system) and should encourage full resumption of the functions of a self supporting interbank market as an integral part of the management of maturity risks linked to the bank’s loan books and other portfolio assets. This mechanism would also smooth the withdrawal of liquidity by the ECB allowing it to be replaced by the traditional interbank market. A clearing mechanism for USD interbank lending could be set up in parallel.

 

There is ample time to set up such a system in anticipation of the time when temporary government guarantees on interbank lending are set to expire. Failing to prepare for this could create further disruption in the interbank market if individual financial institutions find their access to the interbank market impaired as a result of the “counterparty risk” associated with them. Such a mechanism should also have a stabilising impact on CDS spreads whose past volatility has been a key factor in spreading mistrust between interbank market participants.

 

Conclusion:

 

Managing an appropriate “exit strategy” for the financial crisis will prove at least as difficult as managing the crisis itself. The early recognition of this problem augurs well to the extent that the well meaning declarations are followed by appropriate action.

The “window of opportunity” in terms of preparing for the exit offered by the continuation of the crisis should be put to full use. This should be translated concretely by the rapid passage of the legislative proposals concerning the reform of the regulatory architecture of financial markets, the implementation of the key decisions taken at the G20 meeting in London, the testing of mechanisms of reinforced cooperation at global level and a further integration of the regulatory framework at Eurozone/EU level. In addition we suggest as described more fully above two new initiatives:  the setting up of an interbank market clearing mechanism in each significant currency area and the inclusion of the concept of managing “recovery expectations” in the panoply of tools used by the ECB in conducting its monetary policy.

 

19:22 Écrit par Paul N. Goldschmidt 13 Ave. Victoria 1000 Bruxelles dans Général | Lien permanent | Commentaires (0) |  Facebook |

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