Now that governments’ reactions to the credit crisis stampede seem to converge – with central banks being responsible for bank liquidity and the government taking care of bank equity capital – it is time to ask: will this mix of financial market intervention do the job? Will the provision of ample central bank credit lines, a guarantee for interbank lending, the takeover of bad assets and an injection of public equity into private banks end the lack of trust and the dwindling of market expectations?
Almost unambiguously, the current cocktail of government interventions aroused applause from commentators and analysts alike. Nevertheless, expectations of a market recovery are premature, if not fully displaced. The reason is, we believe, that all we have seen so far in terms of government intervention is part of an emergency rescue package, addressing symptoms rather than the cause of the crisis. Let us look at these measures before turning to the deeper issue of crisis resolution.
The current wave of central bank and government interventions initially focused on the interbank market, in effect guaranteeing access to central bank funding. This is a much needed measure in an emergency case. However, it is untenable as an enduring assistance, since it destroys the interbank market by crowding out private lending. The correct policy prescription for the medium term, therefore, emphasises default risk insurance for interbank lending through the government. Even better than one-size-fits-all insurance schemes is a scheme that utilises credit default swaps as an instrument allowing the central bank, or a designated professional agency, to fix the terms of the insurance contract in a flexible way. Initially, these credit default swap rates could be set below market price, even reaching negative levels, in order to kick start lending between banks. Over time, as the market stabilises and trust between banks returns, swap rates could be increased to market levels and beyond, if the central bank wants to back out eventually.
Next consider the Paulson rescue plan (Tarp) and similar buyout plans for distressed assets planned in France and Italy. We expect these plans to be short-lived and to have little success, since they are conceptually inconsistent. The idea is to free financial institutions from poor assets. Unfortunately, and despite the huge amount of money involved in these plans, they are likely to disappoint the market and they will have little or no effect on the mistrust between banks. The reason is that a reduction of poor assets on one bank’s balance sheet does not does tell the market anything about the quality of the remaining assets. Therefore, even after the Tarp billions are spent, investors and peer banks will not know the worth of the remaining bank assets. Illiquidity will presumably persist.
Finally consider equity participation, which is now the rescue model of choice in the US, UK and Germany. This is probably the best of all the measures discussed so far, since it avoids the pitfalls of the asset buyout programme. But we should expect at most a temporary relief. The simple reason is that for equity to be useful here, positive business prospects are required. Otherwise, equity injection can merely be a drop in a bucket. Remember that leverage ratios among international banks, particularly in Europe, are extremely high today, with debt-to-equity ratios sometimes exceeding 30:1.
What these arguments suggest is the following: in order to restore market functionalities, the causes of the financial crisis need to be addressed now. This implies a new quality of intervention, aiming at institutional measures for the long term rather than short-term rescue packages. In our view, a strong candidate for a structural explanation of the credit crisis of 2007-08 is the industry’s negligence concerning very basic lending and monitoring incentives. Incentive alignment was violated by poor financial engineering, as can be seen in the carelessness with which some institutions were apparently selling equity pieces – without making proper adjustments for repercussions this might have on asset quality. By a similar argument, compensation schemes were devised that induced increasing asset risk and leverage ratios. Both cases of incentive misalignment will sooner or later undermine the value of the underlying portfolio. This induced systematic deterioration of asset quality is, in our view, the main driver for the widespread loss of confidence in financial instruments as well as financial institutions experienced over the past 18 months.
An important first step to address the concerns just mentioned will require the market to know, on a continuous basis, whether or not management incentives are aligned. We propose several measures to improve transparency and it give regulators the role of enforcing this transparency.
1. Markets need to know at all times the size and the fraction of first-loss position retained by the originator of a security. There should not be mandatory retention, however, because a rule can always be gamed.
2. Compensation schemes of managers need to balance bonus and malus components (those that penalise poor performance). Again, no regulation is required, only transparency on remuneration policy, including an independent assessment of incentive properties of the scheme, eg by rating agencies.
3. An extra capital charge should be imposed on banks whose risks are opaque, reflecting the externality imposed on the market as a whole.
4. Rating processes should not be regulated, while rating performance measurement (ie the validation of ratings) should – and be made public. Also, ratings should provide information on incentive alignment in complex transactions.
5. Comprehensive data on risk exposure of financial intermediaries (a risk map) should be collected and published quarterly, signalling early warnings.
A perspective is now needed on how markets can regain their credibility. Without such a master plan the taxpayer’s money pouring into liquidity and recapitalisation programmes will dissipate quickly - with no lasting effect on the functioning of credit markets.
Günter Franke is professor of finance, Konstanz University, Germany. Jan Pieter Krahnen is professor of finance, Centre for Financial Studies at Goethe University Frankfurt, Germany
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