Published October 8, 2008

COMMENTARY
Making sense of the post-bailout meltdown

US needs to urgently recapitalise its banks and Europe must get its act together fast

By VIKRAM KHANNA
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THE global stockmarket meltdown in recent days and the still-frozen state of the interbank markets are clear signs that market participants have given a thumbs-down to the way the authorities in the United States and Europe are dealing with the worst financial crisis in 80 years.

The US$700 billion bailout package hastily put together by the US Treasury and the Federal Reserve has been far from effective in soothing market panic. While the case can be made that an imperfect package is better than none, after the package was passed by the US Congress and signed by President George W Bush, the market started focusing on its imperfections.

Unfortunately, these are considerable. Much of the money is intended to be used by the US Treasury to buy, in stages, the toxic assets off the books of US financial institutions. It is hoped that once they get rid of their junk, the institutions will resume lending as well as rebuilding their capital.

However, there are big holes in this story. One problem is the price which the Treasury will pay for the junk. If it's the current market price (which is very low, if not zero), the banks would end up getting little help - and in fact would probably not even accept the deal (which is what happened in Japan in the 1990s; banks simply refused to step forward and admit how much junk they were carrying).



On the other hand, if it's an artificially inflated price - which would require a suspension of mark-to-market accounting norms - there would be an uproar among taxpayers about overpaying Wall Street at the expense of Joe Sixpack.

The other problem is that the bailout plan does not directly address the issue of recapitalising the banks. While this might indirectly happen over time if banks were able to get the bad assets off their books and rebuild from there, the pricing problem mentioned above (plus the likely slow pace of recapitalisation) inspires little confidence.

Thus, many economists propose that another bailout plan is needed - which focuses on recapitalisation. This could be done via a direct injection of public funds into the banks, in return for preferred shares, with matching contributions by existing shareholders (to minimise costs to taxpayers). But however it is done, bank recapitalisation is of critical importance; a recent IMF study of 42 systemic banking crises showed that the vast majority of cases involved the government intervening to recapitalise financial institutions.

Meanwhile, to prevent bank runs, the US Federal Reserve needs to announce that it will stand behind any financial institution that experiences a run. Deposit insurance needs to be expanded as well. The markets are still waiting for all of this to happen.

But while the US is doing its best to deal with a systemic problem in a systemic manner - even if imperfectly - Europe is not even trying. The European Central Bank has a mandate to act on interest rates (and, bizarrely, raised interest rates early this year) but has no Europe-wide regulatory mandate. This is left to regulators in individual countries. And, so far, they have acted in total disregard of the consequences of their actions on other countries.

Ireland, for example, recently announced that it would guarantee all deposits in Irish banks. So money fled from all corners of Europe to Ireland. That forced other countries - starting with Germany and Denmark - to announce full deposit insurance as well. Germany, meanwhile, has so far refused to endorse a pan-European response to the crisis, even as it is obvious that the balance sheets of European banks are closely interconnected. And if Germany says no, no Europe-wide initiative is possible.

Eventually, a coordinated response will happen - because markets are unlikely to stabilise until it does. What we are seeing then is financial devastation caused by bad banking practices - and aggravated by inadequate policy responses.