IMF: A systemic crisis demands systemic solutions

Source: Financial Times | OpEd by Dominique Strauss-Kahn*

These are exceptional times. Exceptional for what has happened to financial markets and for what has not happened, at least not yet, to the broader economy – the onset of a severe recession. Perhaps it was the absence of the latter that lulled too many into viewing the bursting of the housing bubble merely as a correction, the defaults in US subprime mortgages just as misfortune and the failure of important financial institutions as collateral damage.

Six months ago, when the International Monetary Fund estimated more than $1,000bn (€691bn, £546bn) in financial sector losses and predicted a sharp slowdown in the global economy, we were criticised for being too pessimistic. But with much of the losses yet to be realised, and with the financial crisis now acute, it has become clear that nothing short of a systemic solution – comprehensive in tackling the immediate fallout and comprehensive in addressing the root causes – will permit the broader economy, in the US and globally, to function with any semblance of normality.

For the near-term, such an approach must include three elements: liquidity provision; purchase of distressed assets; and capital injections into financial institutions.

First, central banks must prevent runs on banks and financial institutions. They can do so by reassuring depositors that bank deposits are safe and by providing liquidity to financial institutions against good collateral. This was the first line of defence and central banks have probably done by now most of what they could do.

Second, treasuries must remove the reason runs come in the first place: the presence of distressed assets on the balance sheets of financial institutions. An effective way is to set up a government agency to buy these assets and hold them until they mature and can be safely resold. A key issue will be the price at which these assets are acquired: high enough to induce financial institutions to sell, but also low enough for the state to have a chance of making a return and keeping its own long-term finances in order. There are also other, potentially less costly, alternatives. Early this year, the IMF proposed a solution based on longer-term swaps of mortgage securities for government bonds – which cleans up bank balance sheets but leaves the long-term risk with banks, not the taxpayer.

Third, the financial system must be recapitalised – at this point, probably with public support. At the core of this crisis is the fact that the financial system has too little capital. Even as the system shrinks and bad assets are removed, many institutions will still lack sufficient capital safely to extend fresh credit to the economy. It is possible for the state to provide capital to banks in ways that do not imply nationalisation. For example, many IMF members in the past have matched private capital injections with preferential shares and forms of capital that left ownership control in private hands.

I welcome the bold steps being taken in the US and look forward to their effective implementation. Other advanced economies should also be preparing comprehensive contingency plans, not least because of the complexity of dealing with the failure of institutions with extensive cross-border linkages. To the extent that comprehensive approaches are put in place, I am confident that financial systems that had grown too large relative to the economy will stabilise at a more appropriate level. But what about the long-term challenges?

*The writer is managing director of the International Monetary Fund

To read the article in its entirety, please click here.