Global finance ministers and central bankers meet in Washington at the G7 and the International Monetary Fund this weekend to discuss a response to the global financial crisis.
A coordinated approach by the world’s major economies to strengthen the banking sector is urgently needed to stop the financial market carnage, analysts say.
Restoring confidence is the top priority. But the complexity and global nature of financial interlinkages make solutions difficult to agree upon or even to implement.
Ad-hoc packages of national measures have so far failed. Analysts say individual country efforts must be globally coherent and internationally reinforcing.
Here are some of the ways that could be achieved:
MONEY MARKET/INTERBANK GUARANTEE SCHEMES
Getting short-term money markets working again is critical to keeping the gears of the financial system greased. Momentum appears to be building toward guaranteeing these borrowings.
The UK government’s promise to guarantee short-term lending between banks, known as the interbank borrowing market, could be a template for Europe and other G7 countries to follow. It would help unlock frozen money markets because it would give ailing banks a top credit rating and other banks would be ready to extend credit to them again on a daily basis.
The International Monetary Fund said on Friday guaranteeing bank deposits and interbank operations was “unavoidable”.
British Prime Minister Gordon Brown has written to leaders of the world’s major economies for concerted action to guarantee lending among banks, according to a G7 source.
Britain offered to guarantee up to eight UK banks’ new short and medium-term debt, estimated to cover up to 250 billion pounds ($428.85 billion) of new borrowing.
If successful and followed across Europe and beyond, many analysts reckon money market tensions might start to ease.
There is no single Treasury authority serving the 15-nation euro zone or 27-nation EU. But analysts say the European Investment Bank (EIB), the policy lending arm of the EU, could step into that space.
CAPITAL INJECTIONS/NATIONALISE BANKS
Stronger capital could encourage banks to lend to each other. Pumping taxpayer money into crumbling banks could be the key to giving them the capital they need to begin lending again. Governments around the world could take equity stakes or nationalise institutions.
Injecting capital into several banks at the same time could remove the current stigma that an individual institution is in need of funds. This could help prevent a run on the banking system.
Taxpayer wrath at bailing out failing bankers means governments will look for ways to benefit from any subsequent recovery in share prices. By buying preference shares that pay an annual dividend, governments would allow taxpayers to benefit. Other mechanisms could include offering warrants or convertible shares for government cash pledges.
GLOBAL DOLLAR RESERVES ARE MOBILISED
The scale of the crisis may justify wholesale use of the $4.5 trillion of U.S. currency stashed in global central bank vaults — the foreign exchange reserves traditionally held for use in times of national economic emergencies.
Policymakers could agree to sell dollars from these reserves to meet the extraordinary demand for the U.S. currency.
A dollar shortage around the world has become the crux of the 15-month-old financial crunch because the near collapse of many U.S. mortgage-related assets has sent banks in Europe and elsewhere scrambling to find dollars to repair balance sheets.
The International Monetary Fund estimates that major global banks will need about $675 billion in additional capital over the next few years and says recapitalisation using the public sector balance sheet should now be considered.
A simple explanation for why reserves might need to be used in this way is because when a European bank takes a 50 percent writedown on a $2 billion asset, it still has to roll over $2 billion of short-term dollar financing all the way to maturity, even though the asset is then only worth $1 billion.
The writedowns themselves fuel counterparty distrust on interbank lending markets and make rollover beyond overnight loans extremely difficult. A big problem is that the writedowns create a currency mismatch on banks’ books.
In the simplified example of a 50 percent writedown of a $2 billion asset, the notional European bank will end up with a $1 billion dollar net short position — one its auditors will require it to cover by buying dollars to avoid the exposure.
Significant net redemptions of dollar debt are expected in Europe through the final quarter of 2009 and must be met with dollar cash.
Central bank intervention to sell dollars cannot be ruled out, in the event that the rush to hedge net dollar liabilities creates an increasingly disorderly FX market, analysts say.
NEW REGULATORY STRUCTURE FOR BANKING
International banks operate branches in multiple countries with many different regulatory structures. This makes it far more difficult for a single government to solve the crisis by buying assets directly off bank balance sheets, recapitalising domestic banks, or laying down new national operating rules.
In the United States, for instance, there are five different types of bank regulators. In the European Union, each of its 27 members has a separate national regulatory regime.
An international agreement on a harmonised regulatory structure would bring common standards for cross-border banks and speed up the process for resolving failures in the global banking system.
It also could address whether changes in capital standards are needed to replace the Basel II regime, which currently is being rolled out and tiers different types of risk.
NEW REGULATION FOR CREDIT DEFAULT SWAPS
The $55 trillion credit derivatives market has fended off regulation so far, but as the chorus blaming it for the current global financial crisis grows, some form of regulation seems inevitable. Critics say the lack of regulation makes the CDS market ripe for fraud and manipulation.
In one approach, New York state authorities intend to regulate from January 2009 those credit default swaps that it regards as insurance contracts. Analysts say classifying some CDS as insurance would reduce the speculative bubble by helping to identify the investors with real credit exposures to hedge.
Another approach could be to move credit derivative trading onto exchanges to provide price transparency and offer simpler, standardised contract settlement in the event of default.
The exchanges initiative has failed to catch on with banks so far. They have preferred to protect the income they collect from trading credit derivatives privately.
Clearing Corp, a dealer-owned clearing house, is expected to launch in early 2009 a central system for matching CDS trades which is now done by individual banks.