Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Governments Must Take Stronger Measures to Strengthen Banks

January 28, 2009

  • IMF raises estimate of U.S.-origin asset writedowns to $2.2 trillion
  • Problems spreading from banks to other financial firms and countries
  • IMF says "bad bank" approach may be useful to remove distressed assets

Financial markets around the world continue to deteriorate in spite of extensive policies by governments to stabilize the situation, according to the International Monetary Fund in its latest assessment of global financial stability.

Global financial crisis

Governments must take even more aggressive actions, including countenancing creation of special institutions that would buy bad assets from distressed banks, the IMF said in an update of last October's Global Financial Stability Report (GFSR).

The IMF raised its estimate of potential financial sector writedowns on U.S.-origin assets alone by $0.8 trillion from its October 2008 estimate of $1.4 trillion to $2.2 trillion. Much of the recent deterioration in the value of U.S. assets occurred in corporate and commercial real estate securities, the GFSR said. Bank loan losses are also rising, "reflecting the weakening economy." Moreover, problems are spreading to other financial sectors including insurance companies, pension funds, and hedge funds. And in addition to U.S. assets, the deterioration is affecting assets in Europe and in emerging market countries.

The crisis in financial markets—which began in 2007 among subprime mortgages in the United States but has to spread to other markets and to much of the rest of the world—has resulted in a global recession that also continues to worsen. In its revised World Economic Outlook—released simultaneously with the GFSR update on January 28—the IMF said the prospects for global growth have markedly dimmed and international trade has slowed sharply.

So far banks have obtained enough new capital to offset existing writedowns, but that is mainly because of the injection of public sector funds during the final months of 2008. Even so, some banks may not have a big enough capital cushion to "weather a global economic downturn," the GFSR said.

Briefing reporters, Jaime Caruana, the IMF's Financial Counsellor, said that estimates of capital needs were difficult to assess. "But for European and U.S. banks, (including their exposure to assets domiciled not only in the United States, but also in Europe and emerging markets), our rough estimates indicate that at least half a trillion dollars is necessary to prevent their capital position from deteriorating further," he said. "We also emphasize the need to clean up banks' balance sheets to raise the level of confidence in the banking system."

More decisive action needed

As a result, the IMF said, policymakers and the private sector must take even more "decisive and urgent action" to strengthen the system and to short circuit the adverse "feedback loop" through which bank actions to reduce their exposures by selling assets and refusing to renew maturing loans cause a further weakening of the economy, which in turn increases pressures on banks sell more assets and further restrict credit.

The report said economies will not recover until the global financial system returns to health. In the October GFSR, the IMF recommended a three-pronged approach to nurse financial markets back to health:

• Central banks must provide ample liquidity to the financial system.

• Banks must be recapitalized to cover potential writedowns.

• Problem assets on bank books must be dealt with in some manner.

To date, the IMF said, "policy measures to cap potential bank losses and inject capital have not yet stemmed concerns about the health of the financial system ... The speed and size of the impact of the adverse feedback loop between the economy and the financial system has overwhelmed policy responses so far," the IMF said. Aggressive "actions by both policy makers and market participants are needed to ensure that the necessary deleveraging process is less disorderly."

The IMF recommended a comprehensive and internationally coordinated approach that includes the following elements:

Speedy efforts to recapitalize banks and take care of distressed assets. Authorities may find a "bad bank" approach useful whereby good assets are left on the books of recapitalized institutions and impaired assets are sold to the "bad bank," which can hold them to maturity or dispose of them. Such an approach has proved effective in previous crises, the IMF said. The Resolution Trust Corp, for example, was created by U.S. authorities to dispose of bad assets during the savings and loan crisis of the 1980s.

A recognition that short-term policies must be consistent with the long-run vision for the financial system. Unless authorities are clear about the final design of the financial system and how actions such as cleansing bank balance sheets fit into that vision, "the credibility of the policies will come under question."

Transparency about policies, the use of public financial support, and decisions about the future of any individual financial institution. This applies in particular to the authorities' identification of bank problem assets, application of conditions to bank recapitalization, and the setting of capital levels that are adequate.

• A high level of international cooperation on national financial policies to support institutions to prevent competitive distortions, regulatory arbitrage and excessive "national bias" that might harm other countries. "No one model of restructuring will be appropriate for every country or every bank, but even if the models differ, international coordination remains essential."

In the medium run, the report said, the initiatives under way to improve the regulatory and supervisory frameworks will be crucial to building a resilient and innovative financial system.

Comments on this article should be sent to imfsurvey@imf.org