Kiel Institute Focus 3

Solving the Financial Crisis: A Problem-Oriented Strategy*

by Dennis J. Snower

Governments face two alternatives in dealing with the financial crisis. The first option is the “fingers crossed” strategy: hope that the worst is over and do the minimum necessary to support large financial institutions that may still start to wobble.

This is smart if the financial crisis has now been overcome, since this strategy prevents wasting money. Unfortunately, the sources of the financial crisis persist and thus the crisis itself cannot be considered vanquished.

There are three important reasons.

First, the financial crisis was spawned through deficient regulation and supervision. This problem has not been solved. Second, we still have not overcome the solvency problem. Third, huge capital infusions are offered to failing financial institutions, which attempt to hoard the cash rather than lend it to desperate businesses with basically sound business plans.

Unless these problems are solved, we face the danger that the financial crisis will ignite afresh. That brings us to the second policy option, to find a cure designed to defeat the underlying disease. In my judgment, the following package could do the trick:

The systemically relevant financial institutions should be identified.

The government would then give these institutions a solvency guarantee – irrespective of whether they ask for it. That solves the solvency problem.

These institutions would receive commensurate regulation and supervision.

The regulation would specify capital adequacy ratios that depend on the risk and transparency of the underlying financial products.

That addresses the problem of deficient regulation.

The solvency guarantee would be financed not just by the taxpayer, but also by the bond- and stockholders. This can be ensured through debt-for-equity swaps, whereby the bond holders are turned into stockholders.

Then the bondholders contribute financing of the solvency guarantee since the value of their equity falls short of the initial value of their bond holdings. The stockholders contribute by absorbing a dilution of their equity. This is what happens, de facto, when companies go through Chapter 11, except that the debt-for-equity swaps for the systemically relevant financial institutions should not be voluntary, but imposed by the government as a prerequisite for its capital infusion.

What are the risks? The swaps would increase the future financing costs of the institutions, since future bond holders would take account of the risk of loss through the swaps. Thereby the debts of these institutions would rise.

Would the government then have to bear this additional debt as well? No.

The government would announce in advance what the taxpayers’ contribution is to be. The rest of the adjustment takes place through the debt-for-equity swaps. If the future financing costs rise, more swaps would be required to ensure solvency.

Would the higher financing costs harm the financial system? Again No.

The higher costs simply reflect the actual risks of the financial institutions. The institutions come to bear the costs of their risks, and thereby we avoid another source of the financial crisis – the decoupling of risk-taking from the costs of that risk.

But are not the adjustment costs from this strategy at least as large as those from the “fingers crossed” strategy? Quite the contrary. We have the choice between a financial system in which the risks from reckless transactions remain implicit and intransparent, and a transparent system in which regulation, oversight and the swaps reveal the risks and adjust asset values accordingly. In both systems, the costs of reckless behavior must be borne, but in different forms: in the transparent system through the reduction of asset values and in the intransparent system through insolvency risk.

But the costs in the intransparent system are far higher. If a systemically relevant financial institution collapses, a chain reaction of confidence reduction ensues that threatens the existence of other systemically relevant institutions, as well as countless other enterprises in the real economy. Although initially the costs of risk revelation (in the transparent system) are equivalent to the costs of insolvency risk (in the intransparent system), the latter costs get multiplied through financial contagion.

We urgently need to adopt the problem-oriented strategy. The longer we wait, the more we allow the financial contagion to spread.

(Slightly revised version of an article published in the Financial Times Europe on December 18, 2008).

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*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.