Bolder solutions needed

Even with the passing of the USD700 billion bailout package ("Bailout Plan Wins Approval; Democrats Vow Tighter Rules" by David M. Herszenhorn, The New York Times, 03 October 2008), the financial crisis is not being contained in the United States. It has in fact been spreading across the globe, causing Central Banks around the world to coordinate in cutting their interest rates. (Central Banks Coordinate Cut in Rates, by David Jolly and Keith Bradsher, The New York Times, 08 October 2008)

I agree with the points mentioned by Paul Krugman in his article "Thinking the bailout through" published in The New York Times on 21 September 2008. The USD700 billion is only going to clear some of the troubled mortgage backed securities and not all of the problematic assets. In addition, the selection by the US Government and the Federal Reserve to choose who to save and who not to save has resulted in banks worrying which financial institution would be next to go. These actions have resulted in not just a minor crisis of failing mortgage-backed securities but a liquidity crunch.

Banks are fearful of lending out their money to borrowers. Depositors are fearful of banks who are involved in this crisis to be failing. What is happening, seems to be a total lack of confidence in the banking industry. Depositors could be fleeing to financial institutions who are not involved in this crisis, as a means to safeguard their assets. If this is the case, there could be massive flow of funds from the ailing financial institutions to the healthier ones, which could cause the former to fail. If more financial institutions fail, the effects would spread even to the healthier ones and contagion would just occur with a never-ending cycle.

What can be done to stem this once and for all?

1) Establish all deposits to be safe. Be it from the rich, poor, retail or corporate. This is to give confidence to depositors and preventing a liquidity crush for the ailing banks. (This has to be mainly by the Federal Reserve as it is the US financial institutions which are in trouble and pulled the rest of the banking world onboard.)

2) Establish rules permitting that bank to bank loans would be honoured by the Federal Reserve should the borrower bank fail. This is to provide confidence to other financial institutions and immediately reduce the default risk of loans by banks.

3) Establish strong regulations during this period of time that financial institutions have to rein in the unsecurred credit facilities provided to clients (with the exception of banks). For secured credit facilities, there should be a limit as to the loan amount that can be provided, say around 50% of the market value.

However, the above suggestions can be very difficult to implement. With the total guarantee on deposits and bank to bank loans, the Federal Reserve would be putting more taxpayers money on the table. Moral hazard would be dealt with when the regulations on credit facilities are implemented, but the time frame of over-hauling regulations is long and tedious.

The market may react to the news in a unexpected positive manner even though it may not be implemented yet. We'll only know, if these are truly implemented.

In the meantime, let's prepare ourselves for a long drawn financial crisis.