Opinion: Stocks may be rallying but the global banking system is still in a mess

By Neville Bennett There is a disconnect between the real world and Wall Street. Wall Street prices surge while real economy difficulties increase daily. Exports are falling, house prices are declining, and no-one can sell cars. However, there is a perception of "green shoots" that indicate that the real economy may recover quite soon because the financial sector has recovered, and a bull market is underway. The financial sector, however, has been singled out by the IMF for a thorough review. It emphasizes the key challenge of breaking the downward spiral between the financial system and the economy. The IMF believes that "promising efforts" are under way to redesign the global financial system to provide a more resilient platform for sustained economic growth. Overview The financial sector needs mending. Banks and corporates need refunding, balance sheets have to be bolstered, and capital needs to flow across borders, especially to the emerging countries. There is on-going destruction or corruption of assets, and the latest IMF estimate of write-downs has increased from US$2.2 trillion in January, to a possible US$4 trillion in April. The increase arises partly because of worsening picture of economic growth and the spread to other mature market-originated assets. About a third of newly-emerging write-downs will be incurred by non-banking institutions. There have been some improvements in interbank markets but funding remains a difficult issue, especially long-term funding. In some jurisdictions, banks can issue government guaranteed, longer term debt. But the funding debt is big, with the result that many corporations are unable to obtain bank-supplied longer term debt or even working capital. Present Risks The crisis has deleveraged asset prices causing much distress. Some Pension funds and Life Insurers are now underfunded. Some managed their risks prudently, but others undertook risks which they did not really understand. The greatest problem is, however, the decline of cross-border funding. Emerging market economies desperately need refinancing, probably to the tune of US$1.8 trillion in 2009. They had relied on private capital flows but these have been reversed. Although there have been massive fiscal stimulus packages already, further policy action is necessary to restore confidence and thereby relieve uncertainty. Uncertainties are "undermining the prospects for an economic recovery". The cost of these packages is causing concern, especially when the debt burden combines with longer-term pressures from an aging population. There is a "home-bias" as officials encourage banks to lend locally and consumers to keep their spending domestically orientated. These are extremely challenging times as officials try to break a downward spiral which is dragging down the financial sector and the real economy. Recommendations The economic recovery will be protracted. The deleveraging process is not over and will continue to be slow and painful. Credit growth will contract in the US, UK, and EU, and only recover after a number of years. But political support for more fiscal and monetary aid by the state is waning. There is a risk that governments will be reluctant to allocate sufficient funds to solve the problem. Restoring the banking system will take several years. Governments should co-ordinate policies to ensure that the banking system has access to liquidity; the impaired assets are identified and dealt with; and weak banks and other viable institutions should be recapitalized. Lessons from previous crises suggest that very forceful measures are required to resolve financial sector weakness. The IMF has tried to assess existing losses and possible future write-downs in Western banking systems in 2009-2010. Its lowest estimate is $275 bn for US banks, $375 for Euro and $125 for British banks, and about $100 bn for other European banks. But the banks must first increase certainty identifying their capital needs and disclosing impaired assets. Bank supervisors must be very strict in evaluating bank claims and business plans. Viable with insufficient capital could get sufficient capital injections from the state to encourage private capital to join in raising capital ratios. While banks use public money, their operations must be closely monitored, dividends restricted, and compensation closely examined. There will be cases to replace top management. Non-viable banks could be merged with others or undergo orderly closure. The difficulty in attracting private capital means deep government involvement is necessary, even to the extent of taking control. But ideally, the banks will be returned to the private sector as quickly as possible. It would be helpful to convert Government holdings of preferred shares to common stock. Funding Needs Bank funding remains highly stressed. Some governments have guaranteed deposits and some forms of bank debt, but wholesale funding is inadequate. Central banks will continue to need to provide ample liquidity for the foreseeable future. Emerging markets are hemorrhaging capital and this will continue over the "next few years". Their central banks will also need to provide ample liquidity, and also perhaps foreign currency through swaps or outright sales. IMF's enhanced resources can buffer the financial crisis. The larger problem in emerging markets is a lack of capital to roll over corporate debt. Government support seems warranted to keep trade flowing and limiting damage to the real economy. The situation warrants devising contingency plans to prepare for large-scale restructurings in case circumstances deteriorate further. Pressure to support domestic lending may lead to financial protectionism. In several countries authorities have stated that banks receiving support should expand their domestic lending. This could crowd-out foreign lending as banks face on-going pressure to delever balance sheets, sell foreign operations and remove risky overseas assets. These policies can damage the global economy. Fiscal issues Credit growth is necessary to sustain economic activity. In countries with fiscal room for maneuver, fiscal stimulus will be welcomed by markets. But markets are showing concern in countries where debt is an issue, and bond yields have increased and currencies weakened. There is a universal need for stimulus now, but this clashes often with issues of sustainability. Governments risk a loss of confidence in their solvency if there are no plans for debt reduction Conclusion Policymakers have to address urgently the present crisis as well as devising a more robust financial system. Improved financial regulation and supervision are key components in preventing future crises by mitigating future systemic risk. The financial system will remain under pressure for years and require massive new funds. http://www.imf.org/external/pubs/ft/gfsr/2009/01/pdf/summary.pdf "”"”"”"”"” * Neville Bennett was a long-time Senior Lecturer in History at the University of Canterbury, where he taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared. neville@bennetteconomics.com www.bennetteconomics.com