Managing the crisis (1)

"Central banks have kept interest rates very low for many years. This has led many banks to seek juicy returns – to protect shareholder value, as they say – by taking unreasonable risks. This has also led to massive foreign exchange reserves accumulation all over the world. The great unwinding must now take place," said Charles Wyplosz in the Financial Times of 21 December 2007.

Yesterday, the Bank of England presented a rescue plan of 62.5 billion euros for commercial banks affected by the credit crisis, the largest rescue plan ever by England's central bank. One of the banks in trouble, the Royal Bank of Scotland, last year still celebrated its conquering of ABN Amro.

"The central banks have done everything they can to keep financial markets orderly. They have taken the risk of feeding the moral hazard beast and what did they achieve? So far, they have avoided the much feared Big Crunch, but the end of the tunnel is not yet in sight," said Charles Wyplosz in the FT of 21 December 2007.

Charles warned that "further cash injection (by central banks) will not provide the permanent solution – the return of interbank lending. For that to happen, banks need to be reassured about each other. Recapitalisation is the only solution."

He added, "If a company has suffered, or is about to suffer, heavy losses, its shareholders will have to partake in the trouble. Delaying tactics prolong the misery without solving the problem, which will not go away. We now see that the willingness of central banks to provide liquidity at reasonably low cost is only allowing the shareholders to delay the time of reckoning. (...) The message must now go out: unless banks take up their losses and raise the required amount of capital, there will be no more liquidity."

Charles saw a simple solution: let the Sovereign Wealth Funds buy the shares needed to recapitalise the banks.

Stephany Griffith-Jones and José Antonio Ocampo have written an interesting paper on Sovereign Wealth Funds (SWFs) from a developing country perspective. They observe that these funds "have helped calm fears about banks' solvency and helped contain the inevitable reduction of share prices."

"A reason why SWF investment in banks has been welcomed," they observe, "is because they tend to take relatively small shares in banks, and none of them sit on bank boards. Additionaly, SWFs are perceived as having longer term horizons (for example as compared with private equity or hedge fund investors) which makes them less sensitive to market volatility."

In a next post, I will highlight other points in José Antonio and Stephany's paper. I will also report on an insightful article, "Financial Regulation: Sending the Herd over the Cliff. Again", I just received from Avinash Persaud and of which a version will appear in the June edition of the IMF journal Finance & Development.

What do you think of the Bank of England's rescue plan? Is it good? Is it bad? Is it nor good nor bad?