Facing the Future

Facing the Future
Deleveraging and Regulatory Reform

DR. Laura E. Kodres, Division Chief, Global Financial Stability Division, IMF

Back in early 2007, we had hints that the subprime mortgage market in the United States was starting to experience problems. Delinquencies on mortgages written in 2006 began to rise and now, we see delinquencies approaching one-half of all subprime mortgages written in 2007.

The crisis has clearly spread to other markets—first, prime mortgages, then commercial real estate, and now, to household credit. Why are we are witnessing this credit deterioration in areas outside residential housing? Part of the answer lies in the fact that the real economy is now affected and is intertwined with the problems in the banking sector. As banks’ balance sheets are impaired, they need to delever--that is, either raise capital or reduce assets. Since the uncertainty surrounding the worth of their balance sheets and business strategies is so profound, it is nearly impossible to obtain private capital now, so reducing assets is bearing most of the brunt. This is done through asset sales and tightened credit standards. Without credit, there is less spending and less economic activity. This adverse feedback loop has yet to be arrested.

While we have seen earlier periods of deleveraging, the difference with this crisis is its breadth—this is truly a global crisis. We are seeing a collapse in cross-border lending, driven by increased home biased tendencies, impaired cross-currency and FX swap markets, and regulatory capital concerns. For countries that depend on credit flowing from advanced economies, this has been devastating.

A Look Ahead
What can we expect in the next 6 to 12 months?

Consumers, at least those in the G-3, are not very confident about their economic situation. Without a durable improvement in their spending behaviour, we are unlikely to experience a sustained recovery.

The health of emerging market sovereign entities--as measured by the spread of their earlier restructured debt—also doesn’t look good. While we expect emerging markets to have difficulties with their sovereign debt, investors are beginning to factor in the costs of the mature market banking system problems and the costs of the packages meant to stimulate the economy—and they don’t like what they see. The extensive provision of financing and the transfer of balance sheet risk from the private to the public sector has put pressure on sovereign credit risk.

So where do we go from here? Can we influence the future? First, we should recognize that the financial system must delever—there is no getting around it. The key is to allow it to delever in an orderly fashion. How can that be done? A three-pronged approach can put the deleveraging on a more orderly path: ample liquidity and term-funding support from central banks; bank recapitalization and measures to address problem assets.

While ongoing efforts address these areas, they fall short of what is needed to stabilize the system. That said, the largest risk to the success of these policies is political—whether enough public resources can be marshaled in the near term to arrest the spiral between the real economy and the financial system. Looking to the longer-term agenda, the IMF has identified several areas that require regulatory attention— regulatory reforms that should result in a more stable financial environment. If adopted, the vision would be:

First, the financial world will likely be less leveraged, have lower credit growth, and will be less cyclical.

Second, managers of financial firms would be paid not just on a return basis—but on the basis of longer-term, risk-based measures, lowering incentives for outright risk taking.

Third, financial firms would find it in their interest to not contribute to systemic risk and would therefore naturally diversify themselves to look different from other firms.


Transcontinental Media G.P.