Policy Responses to the Financial Crisis
This study finds that the global financial instability was mainly economies and currency areas of the world, with lax regulation of financial markets in general playing the role of a permissive factor.
The urgent task at this juncture is to stabilise financial markets and halt the poisonous spiral of lower asset prices depressing economic activity, which in turn is pushing asset prices even lower. The central question is how to restore confidence in the banking system. To this end, the deployment of government money into insolvent banks should be accompanied by a straight takeover by the state, a restructuring phase and resale to private investors as soon as possible.
The arsenal of crisis-management tools available to the European Central Bank are narrower than that of other major central banks because, unlike the Federal Reserve and the Bank of England, the European Central Bank is not backed by a fiscal authority. One way to tackle this weakness without undermining the ECB’s independence would be to create a European Fund which would issue Eurobonds and make the proceeds available to European institutions for their financial rescue operations. Once the crisis subsides, the world will need new monetary arrangements whereby external payment imbalances are corrected by appropriate domestic policies and exchange rates can vary consistently with the requirements of international adjustment. Agreement on restoring external discipline on national policies of all countries will not come about unless the main emerging economies can take their proper place alongside the industrialised countries in the world’s governing institutions.
Lax financial market regulation has allowed leverage of financial organisations to build up to unsustainable levels. In our view, there is no need to fundamentally change the regulatory architecture whereby prudential regulation basically concerns banking institutions. Non-bank intermediaries, including private pools of capital, do not pose systemic stability risks unless they are financed cheaply by banks with depositors’ money; to the extent that this is avoided, it is not necessary to extend prudential regulation beyond the banking system. There is also no need to return to a system of legal separation between commercial and investment banking, provided there are sufficient disincentives and penalties for banks to engage in capital market activities on their own account.
Our main advice on banking capital requirements is to scrap Basle II rules and replace them with a flat capital requirement calculated with reference to total assets, with no exemptions: the maximum permitted leverage ratio should never again be allowed to exceed a ceiling of ten. We also suggest a number of measures designed to strengthen risk management within financial organisations as well as transparency of information on all market participants and financial instruments. Appropriate incentives should push OTC instruments to migrate to organised clearing platforms.
In Europe, a drastic simplification of the regulatory structure is in order to concentrate at EU level not only rule-making, which in the main has already been accomplished, but also rule implementation, as was argued by the de Larosière Group. More specifically, it is high time that Level Three Committees be given legal powers in coordinating the implementation of EU directives.
