Kiel Institute Focus 2

The Next Steps in Overcoming the Financial Crisis*

by Dennis J. Snower

The G20 countries have a lot of work to do before the present financial crisis is overcome. To gain perspective, we need a clear picture of what mistakes led us into the crisis, how they could be overcome, and which of them have not yet been tackled. Here, in broad brush strokes, is my list of mistakes that policy makers have not yet resolved – problems that need to be solved quickly if the financial nightmare is to be put to rest.

(1) Excessive taxpayer sacrifice: The authorities in all the troubled economies have responded in roughly the same way to the crisis, namely, by providing capital to threatened financial institutions in return for an equity stake. Unfortunately, nobody seems to have thought deeply about how the burden of the bailout is to be shared among the taxpayers, stockholders and bondholders. Clearly we should have burden sharing. If, on the one hand, the taxpayers would carry the entire burden, then reckless financial practices would be rewarded, encouraging even more reckless activity in the future. If, on the other, stock- and bondholders carried the burden alone, the banks would no be sufficiently capitalized to fuel an economic revival.

So, ideally, governments should decide in advance how the burden is to be shared, and then implement the decision by combining their equity purchases of financial institutions with the imposition of debt-for-equity swaps on the bondholders. Thus, whereas the taxpayers would contribute to the bailout through the governments’ equity purchases, the bondholders would pay via the swaps, and the stockholders would contribute through the dilution of their equity.

But what has actually happened is that governments have offered eye-popping amounts of capital to the financial institutions without demanding any simultaneous contribution from the stock- and bondholders through debt-for-equity swaps. This policy is misguided: investors worry that the promised capital injections by the government may be insufficient to save the financial institutions, taxpayers worry about their exposure, while the stock- and bondholders aren’t required to shoulder their fair share of the risks. Debt-for-equity swaps should become a central pillar of the financial bailout. (Such swaps are nothing new. When creditors give bankrupt firms a second chance by foregoing some of their claims in return for equity, they are effectively engaged in debt-for-equity swaps.) Of course, government may in fact wish to make the stock- and bondholders contribute in the future, but the current absence of a transparent, well-defined plan generates needless uncertainty and thereby prolongs the weakness of our financial system.

(2) The missing exit strategy: Having purchased shares in troubled financial institutions, governments need to specify how they intend to return this equity to the private sector. This is important, because governments are generally less capable of running banks than bankers are, particularly once appropriate regulation is in place. Financial markets are likely to suffer if the part-nationalization of banks is open-ended.

So governments should turn their equity over to trust companies, which are given the task of selling the acquired shares over a limited period (say, 10 years), with the sole objective of maximizing profit. Thereby the taxpayers potential loss is minimized. Thus far, this has not happened.

(3) Deficient regulation and supervision: Financial regulation and supervision remains essentially national. Policy makers – and voters – need to recognize that this practice is unacceptable. One reason why we have fallen into the financial crisis is that financial transactions where undertaken where the regulation was weakest. This “regulatory arbitrage” allowed financial institutions to take risks without paying for them. The only way to avoid this danger in the future is through international harmonization of regulation and supervision. Once such harmonization gets under way, the momentum is likely to continue, since the countries left out will face increasing risk premia.

To promote the chance of agreement, it is worth setting modest goals. At bare minimum, we need an international coordination of capital requirements. These requirements must depend on the degree of transparency and simplicity of the underlying financial products. For instance, they must be higher for complex structured credit products such as collateralized debt obligations of asset-back securities than for simple products with few counterparties. In this financially globalized world, we need equal regulation for equal risks – not only in the banking sector, but also in the shadow-banking sector (money market funds, hedge funds, investment funds, private equity firms, etc.). Anything short of this leads us back into the quagmire of regulatory arbitrage and reckless risk-taking.

(4) The failure to tackle the solvency problem: The crux of the current financial crisis is a solvency problem. At rock-bottom asset prices, many financial institutions run the risk that their assets fall short of their liabilities, making them insolvent. Bailing out institutions on a case-by-case basis, as they begin to fail, is a disastrous policy, since it spreads fear and mistrust throughout the financial system, which contributes to the failure of yet other institutions.

To solve this problem, finance ministries should undertake to become “buyers of last resort” for systemically relevant financial institutions (that is, institutions that are too large and contagious to be allowed to fail). Specifically, finance ministries should give these institutions a solvency guarantee and, in return, impose special regulatory requirements. The solvency guarantee would be implemented through a combination of the government’ capital infusion and the debt-for-equity swaps. This means that the systemically relevant financial institutions would have a clear choice: either they accept the solvency guarantee and the associated regulation, or they restructure their business with a view to cease being systemically relevant.

Again, to avoid regulatory arbitrage, some international coordination will be necessary. The criteria for evaluating assets and liabilities would need to be harmonized. Cross-country burden sharing agreements for multinational institutions should be made in advance, since negotiations after insolvency are likely to lead to underprovision of recapitalization.

Buyers of last resort would effectively eliminate the possibility that large, contagious financial institutions become insolvent. Once the financial market players realized this, the deadly mistrust would disappear, banks would start lending to one another, asset values would recover, and the risks of contagion would fall. The crisis would be over.

Thus far governments have formulated no transparent rules about which institutions are to be saved and we suspect that their proposed bailouts fall far short of solvency guarantees. Thus uncertainty lingers.

In short, we still have a long way to go in tackling the root causes of the current financial crisis. Many of the mistakes that got us into this mess continue to prevail. In building a new international financial architecture, governments would do well to focus to pursue the straightforward solutions to the four problems above.

________________________
*The Kiel Institute Focus Series presents papers on current economic policy topics. Their authors are solely responsible for their content and their views or any policy recommendations they may make do not necessarily represent the views or recommendations of the Institute.