Liquidity crisis became solvency crisis after failure of investment bank Lehman Brothers a year ago (photo: Nicholas Roberts/AFP/Getty Images)
GLOBAL FINANCIAL STABILITY REPORT
In its semiannual Global Financial Stability Report (GFSR), the IMF adds that once financial stability has been established, it will be time to start to remove these extraordinary measures.
The GFSR notes that policy responses to the most debilitating financial crisis since the Great Depression have been unprecedented and sweeping. Receding stress in the banking sector and a return to a measure of self-sufficiency in some impaired financial markets are promising signs that these large public sector interventions are working to alleviate systemic risk. They are effective, to some extent, both in calming markets and restoring their functioning, the IMF says in a GFSR chapter issued in September.
Empirical results based on an event study (see Box 1) of key policy announcements in 13 advanced economies over a two-year period—from June 2007 to June 2009—provide a number of policy conclusions for the short run. In an environment of high market uncertainty and counterparty risks—which prevailed in the early phase of the crisis, when concerns were primarily about whether financial institutions had enough funds to meet their obligations—liquidity support announcements by central banks were most effective in normalizing market conditions.
Box 1
Event studies tie news to changes in performance
Financial markets absorb news rapidly, with all relevant information reflected almost immediately in the price of securities. Event studies use this fact to measure the impact on financial markets of news events, such as the announcement of a major crisis intervention by the central bank. The event study focuses on changes in various measures of financial stress during a short period before and after each news event—called the event window. The change in these measures during the event window indicates how effective the crisis intervention announcement was in calming financial markets. In general, a crisis policy announcement is effective if, in response, market stress indicators decline.
But as the crisis evolved from one of liquidity to one of solvency, especially after the failure of the Wall Street investment bank Lehman Brothers a year ago, announcements of bank recapitalization and, to a lesser extent, asset purchases by the public sector were most effective because these measures helped alleviate credit risk (see Box 2).
Long-term effectiveness
It is too early to perform a comprehensive assessment of the long-term effectiveness of crisis interventions in repairing credit markets. In many cases, implementation of the crisis measures is not yet complete and many of them have not yet worked their full effect on economic performance.
Box 2
Intervening to calm markets
Central banks generally provided monetary policy and liquidity assistance to distressed institutions, while governments offered stabilization measures. Policy measures taken in one or more of the 13 advanced economies* studied included
Central banks
Monetary policy
Reduced interest rates
Liquidity support
Change reserve requirements
Expand number of institutions eligible under lender of last resort function
Broaden categories of accepted collateral
Provide foreign exchange as a lender of last resort
Governments
Recapitalization
Buy common stock, preferred stock, or subordinated debt of distressed institutions
Liability guarantees
Enhanced depositor protection
Debt guarantees
Lending to an institution
Asset purchases
Buy bad assets, directly or through bad banks
Guarantee assets
* Austria, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Spain, Switzerland, Sweden, the United Kingdom, and the United States.
Moreover, it is difficult to tie specific crisis interventions to longer-term results. Events subsequent to the intervention and other factors can make it difficult to measure precisely the link between an intervention and developments weeks or months later. Still, the initial conclusions are that some market prices are stabilizing and debt issuance is picking up in response to decisive policy measures. The contraction in credit in most regions is beginning to slow or even bottom out.
Removing the crisis measures
Once financial stability has been established, it will be time to start to remove these extraordinary measures. Authorities must decide when and how to do so and, in general, central banks and governments should be guided by the return of lasting confidence in the health of financial institutions and markets.
Because economic and financial conditions differ across countries, there is no common template for the public sector to decide the timing and sequence of unwinding the facilities—such as asset purchase programs—that they put in place during the crisis.
That said, some general principles do apply to disengagement decisions.
• The strategy for the timing and the manner of unwinding crisis measures should include managing market expectations and clearly communicating to the public both when disengagement starts and how the unwinding strategies will be executed.
• Possibilities for arbitrage should be minimized—whether across sectors in an individual economy or across national borders. Being able to obtain funding cheaply in one country when a guarantee is lifted in another may create destablizing cross border flows. For example, it is preferable, where possible, for countries to coordinate the unwinding of government guarantees on bank debt issuance.
• For government financial sector measures, priority should be given to exiting from support programs that significantly distort financial markets or involve large contingent liabilities for the government, such as purchasing large quantities of impaired assets whose valuations are depressed or guaranteeing bank liabilities. Still, the timing and method of disengagement must be balanced against the condition of financial markets and, specifically, how illiquid or fragile they may still be.
■ Wouter Elsenburg, Andy Jobst, and Kazuhiro Masaki also contributred to this report.
Comments on this article should be sent to imfsurvey@imf.org
