Chapter 1: General assessment of the macroeconomic situation

OECD Economic Outlook, Dec, 2008

Macroeconomic policy requirements

The crisis requires a co-ordinated and multi-pronged approach

To relieve extreme stress in financial markets and eventually restore normal credit market functioning, policy must deal with three problems that are plaguing financial markets: a break-down of trust, under-capitalisation and illiquidity. A multi-pronged approach is called for and, as discussed above, is under implementation. It is important that announced plans are fully and rapidly implemented, and that international co-operation is stepped up to prevent distortion to competition, increase capacity to deal with cross-border bank failure and minimise negative fallout from policy interventions such as cross-border capital flight to guaranteed regions. Indeed, unilateral action within the euro area to guarantee deposits and other bank liabilities forced other countries to do likewise. Conventional macroeconomic policy instruments have an important role as well. The recent weakening in activity across practically all OECD countries, as well as intensifying financial stress and the fall in commodity prices, has led to a clear shift in concern away from combating inflation and toward limiting the extent of the coming downturn.

Immediate actions to relieve the crisis

There are signs the immediate crisis is being brought under control

Guaranteeing deposits and bank lending and providing equity injections have contributed to directly tackling the crisis of confidence that reached panic proportions in early October 2008 when the complete breakdown of credit markets was threatened with potentially dire consequences for the real economy. Indicators of financial stress within the banking system suggest that policy announcements have recently led to some improvements. Bank credit default swap (CDS) rates in the United States and United Kingdom have fallen back to the levels observed before the financial crisis intensified in September. Nevertheless, spreads between three-month inter-bank and expected policy rates remain unusually high, with least improvement seen in the euro area (Table 1.9). These policy actions are also important complements to the massive push by central banks worldwide to maintain money market liquidity and, where necessary, directly substitute for private sector credit markets. Such liquidity efforts will need to be maintained in the short term and if necessary extended further. These combined actions have provided governments with a temporary window to implement long-term solutions.

Policy should address recapitalising the banking sector ...

Increasing insufficient bank capital should be the first policy priority. Concerns about bank insolvency have severely undermined confidence, destroyed trust in the financial sector and virtually brought normal credit intermediation to a halt. The Japanese financial crisis experience in the 1990s suggests that government purchases of impaired assets from banks cannot resolve a crisis if banks remain under-capitalised (Hoshi and Kashyap, 2008). (40) Conversely, the presence of assets likely to undergo (further) write-downs or write-offs on bank balance sheets may also inhibit seemingly well-capitalised institutions from performing their normal functions. At any rate, international experience shows that a rapid recapitalisation of the banking sector is an important ingredient of a successful and fast resolution of a financial crisis (Ergungor, 2007 and IMF, 2008b). (41) Under-capitalised but viable institutions should be recapitalised quickly and insolvent banks should be managed in an orderly fashion with a view to winding them down.

... while ensuring private sector participation ...

Governments faced with banks having extreme difficulty raising private capital quickly and the need to deal with imminent bank failures have resorted in many cases to public capital injections without private sector involvement. Building on the immediate stabilising effects of public capital injections, governments should move to encourage private-sector capital injections and where possible consider applying an implicit market test, for example making further public injections of capital only when they match contributions raised from the private-sector. Other measures to increase private sector capital contributions could include a broad compulsory rights issue. Conditions, such as those imposed by the UK recapitalisation plan, that require participating banks to maintain lending availability at certain levels to homeowners, may seem attractive but could lead to a further misallocation of capital and also delay needed adjustment of the housing market. Governments have also in some cases required the restriction or temporary suspension of dividend payments for banks participating in recapitalisation programmes since they deplete capital. They have also taken preference shares in return for capital injections. This helps to protect taxpayer interest by ensuring a priority claim on bank returns. However, it is important to strike a balance between protecting the tax-payer interest and ensuring that banks take up recapitalisation offers in sufficient numbers to mitigate systematic risk. Banks may be inhibited from participating in public recapitalisation by both the stigma of taking up government assistance and operational restriction conditions that attach to such assistance. It is therefore important that the authorities limit their involvement in the lending decisions of banks.