There are five separate initiatives the authorities need to follow to contain the crisis, reverse some of its effects, and prevent it from happening again. National authorities are best positioned to respond quickly to contain the crisis, international initiatives are required to avoid repetition, and some combination of the two is best suited to reversing its effects.
National authorities can best contain the crisis through two measures.
First, as Willem Buiter has argued, they must revive inter-bank markets by providing a temporary guarantee for short-term unsecured lending between regulated institutions. Central bank disintermediation of inter-bank markets is more costly and less sustainable.
Second, national authorities should also inject preference share capital to institutions that need it on condition of a partial swap of “old” debt for equity. Such involvement by government is best carried out at arms length – in Europe’s case, the European Investment Bank may be a good vehicle.
A critical part of the current crisis is that write-downs of asset prices have so depleted bank capital that many banks are close to insolvency on a mark-to-market basis. These write-downs are caused by the distress prices obtained when selling instruments today that the market cannot easily value because of their complexity and uncertainty over their rating. This leads to the next necessary initiative.
The third thing the authorities should do is to support a more immediate reversal of this process by facilitating the creation of long-term liquidity pools to purchase assets – rather like John Pierpont Morgan’s 1907 money trusts. These pools are best managed by those with long-term liabilities like insurance companies and funds with investor lock ups, but the authorities could capitalise these liquidity pools by issuing ten-year government bonds. Under existing rules, these pools would not mark-to-market, and it is better that long-term investors, not governments, buy assets on a strictly commercial basis. These liquidity pools need to operate internationally and therefore need to be capitalised and organised internationally. The IMF may perform this co-ordination role.
Looking ahead to the next crisisThis is the seventh international financial crisis I have lived through. At the end of each, the focus on avoiding the next one has always been the same trinity: more transparency, more disclosure, and more risk management. This is an inadequate response to systemic crises. At the heart of new, internationally co-ordinated regulatory initiative, there must be counter-cyclical capital charges (a la Goodhart and Persaud 2008). Crises do not occur randomly; they always follow booms. That is my fourth policy initiative.
But there also needs to be a shift in the focus of regulation, away from sensitivity to the market price of risk and notions of equal treatment for all institutions to a greater sensitivity to risk capacity and a better appreciation that diversity is the key to liquidity. This is the fifth step.
Systemic resilience requires different risks being held in places where there is a natural capacity for that type of risk. In the name of risk-sensitivity and equal treatment we ended up with institutions that had no liquidity holding liquidity risk and those with little capacity to hedge or diversify it owning credit risk.
ReferencesGoodhart, Charles and Avinash Persaud (2008). “How to avoid the next crash,” Financial Times, 30 January.