Rehabilitating financial markets

Refet Gürkaynak

In the current period of financial turmoil people are angry about past deeds of financial institutions and skeptical about their future usefulness. Yet, financial markets play a crucial role in our economies and they need to be rehabilitated to better serve their purpose. To start this process, progressive leaders should take the following steps:

Do not punish financial markets
Financial markets provide a valuable service for which there are no good substitutes. Lenders and borrowers have to be matched and risk has to be distributed for a well functioning economy. A knee-jerk reaction to punish financial markets for their past sins will only cause further disintermediation. Policy actions should be geared towards rehabilitating and reforming financial systems rather than penalising them.

Decide on what to do with the shareholders of failing banks
It is clear that banks need recapitalisation, but recapitalisation of the scale required cannot proceed until the question of what will happen to existing shareholders is clearly answered. This is a political question and must be answered by elected leaders rather than implicitly being left to central banks. Nationalisation wipes out the existing shareholders, while buying toxic assets at above-market prices with no further stipulations provides them a gift – and there are a variety of options between these two extremes. The further the decision on this is delayed, the longer these institutions remain in a zombie state. This indecision and the resulting loss of intermediation is what turned the Japanese banking problems into a lost decade. The rest of the world should not repeat this mistake.

Carry on helping financial firms
Many financial firms, which are still healthy at present, will face difficulties as the global recession deepens and nonperforming loans increase. These institutions will have to be helped so that a reasonably healthy financial system will be present to foster growth when the worldwide fiscal stimulus begins to bear fruit. It is important to prepare the public for these further injections of cash into financial firms and make it clear that this is one large, drawn out, financial system-wide bailout rather than the same firms being bailed out time after time. It is also vital to make it clear that the fiscal stimulus and the financial market cleanup are both necessary ingredients of a recovery and that one of these alone will not suffice.

Make organised markets more flexible
Moving large Over-The-Counter (OTC) markets, such as the credit default swaps to organised markets – where clearing and netting, as well as measuring risk taking is much easier – is a reasonable and conceptually simple policy action. This, however, only addresses a single instrument or a few instruments at best. New instruments will continue to be introduced in the OTC market. Legal changes to make it easier to introduce contracts in organised markets and regulatory changes to make this attractive should be considered so that instruments gaining popularity in OTC markets will be moved to organised markets without ad hoc regulatory interventions in the future.

Tailor regulations to the specifics of each country
Financial systems and real economies are intertwined in all countries. Different countries have different production chains, labour markets, real estate sale practices, etc., and therefore different financial sectors to cater for these. A one-size-fits-all approach to financial regulation will not be suitable for these different financial sectors. Better information sharing across national regulators is necessary and there can be a common understanding to promote more transparency in over-the-counter trading, better disclosure of risks and the like. However, financial sector regulation in the end must be tailored for the specifics of each country.

Refet Gürkaynak is professor of economics at Bilkent University