Global Financial Crisis and Restructuring Strategies

Executive summary

The global economic crisis has yet to bottom out. The major industrial economies are in a deep recession
and growth in the developing world is slowing continuously. The danger of falling into a deflationary trap
cannot be dismissed for many important economies. It is equally urgent to recognize the root causes for
the crisis and to embark on a profound reform of the global economic governance system.

No doubt, without greed of too many agents trying to squeeze double-digit returns out of an economic
system that grows only in the lower single-digit range, the crisis would not have erupted with such force.
The sudden unwinding of speculative positions in practically all segments of the financial market was
triggered by the bursting of the United States housing price bubble, but all these bubbles were
unsustainable and had to burst sooner or later.

In this situation, the performance of the real economy is largely determined by the amount of
Outstanding debt: the more economic agents have been directly involved in speculative activities
Leveraged with borrowed funds, the greater the pain of deleveraging, i.e. the process of adjusting the
level of borrowing to diminished revenues. As debtors try to improve their financial situation by selling
assets and cutting expenditures, they drive asset prices further down, cutting deeply into profits of
companies and forcing new “debt-deflation” elsewhere. This can lead to deflation of prices of goods and
services as it constrains the ability to consume and to invest in the economy as a whole. Thus, the
attempts of some actors to service their debts make it more difficult for others to service their debts. The
only way out is government intervention to stabilize the system by “government debt inflation”.

Financial losses in the deficit countries or the inability to repay borrowed funds then directly
feed back to the surplus countries and put at risk their financial system. This channel of infection has
particularly great strength in today’s world, with its obvious lack of governance of international monetary
and financial relations. Another important reason for growing imbalances is movements of relative prices
in traded goods as a result of speculation in currency and financial markets, which leads to considerable
misalignments of exchange rates. Speculation in currency markets due to interest rate differentials has led
to overspending in the capital-receiving countries that is now unwinding. With inward capital flows
searching for high yield, the currencies of capital-receiving countries (with higher inflation and interest
rates) appreciated in nominal and in real terms, leading to large movements in the absolute advantages or
the level of overall competitiveness of countries vis-à-vis other countries.

The global financial crisis arose the failure of the international community to give the globalized
economy credible global rules, especially with regard to international financial relations and
macroeconomic policies. The speculative bubbles, starting with the United States housing price bubble,
were made possible by an active policy of deregulating financial markets on a global scale, widely
endorsed by Governments around the world. The spreading of risk and the severing of risk – and the
information about it – were promoted by the use of “securitization” through instruments such as
residential mortgages-backed securities that seemed to satisfy investors’ hunger for double-digit profits. It
is only at this point that greed and profligacy enter the stage. In the presence of more appropriate
regulation, expectations on returns of purely financial instruments in the double-digit range would not
have been possible.

The process for coping with the crisis by countries across the globe has been manifest in four basic
phases. The first has been intervention to contain the contagion and restore confidence in the system. This
has required extraordinary measures both in scope, cost, and extent of government reach. The second has
been coping with the secondary effects of the crisis, particularly the global recession and flight of capital
from countries in emerging markets and elsewhere that have been affected by the crisis. The third phase
of this process is to make changes in the financial system to reduce risk and prevent future crises. In order
to give these proposals political backing, world leaders have called for international meetings to address
changes in policy, regulations, oversight, and enforcement. On September 24-25, 2009, heads of the G-20
nations met in Pittsburgh to address the global financial crisis. The fourth phase of the process is dealing
with political, social, and security effects of the financial turmoil. One such effect is the strengthened role
of China in financial markets.

If the failure of financial markets has shattered the naïve belief that unfettered financial
Liberalization and deliberate non-intervention of Governments will maximize welfare; the crisis offers an
opportunity to be seized. Governments, supervisory bodies and international institutions have a vital role,
allowing society at large to reap the potential benefits of a market system with decentralized decision-
making. To ensure that atomistic markets for goods and for services can function efficiently, consistent
and forceful intervention in financial markets is necessary by institutions with knowledge about systemic
risk that requires quite a different perspective than the assessment of an individual investor’s risk. Market
fundamentalist laissez-faire of the last 20 years has dramatically failed the test.

A new start in financial market regulation needs to recognize inescapable lessons from the crisis, such as:
• Financial efficiency should be defined as the sector’s ability to stimulate long-term economic
growth and provide consumption smoothing services. A key objective of regulatory reform is to
devise a system that allows weeding out financial instruments which do not contribute to
functional, or social, efficiency;
• Regulatory arbitrage can only be avoided if regulators are able to cover the whole financial
system and ensure oversight of all financial transactions on the basis of the risk they produce;
• Micro-prudential regulation must be complemented with macro-prudential policies aimed at
building up cushions during good times to avoid draining liquidity during periods of crisis;
• In the absence of a truly cooperative international financial system, developing countries can
increase their resilience to external shocks by maintaining a competitive exchange rate and
limiting currency and maturity mismatches in both private and public balance sheets. If
everything else fails, back-up policies, such as market-friendly capital controls, can limit risk
accumulation in good times;
• Developing countries regulators should develop their financial sectors gradually in order to avoid
the boom-and-bust cycle;

• Regulators based in different countries should share information, aim at setting similar
standards and avoid races to the bottom in financial regulation.

As for the growing presence of financial investors on commodity futures exchanges, several
immediate areas are suggested for improved regulation and global cooperation:

• Comprehensive trading data reporting is needed in order to monitor information about

sizeable transactions in look-alike contracts that could impact regulated markets, so that
regulators can understand what is moving prices and intervene if certain trades look
problematic;
• Effective regulatory reform should also close the swap dealer loophole to enable regulators to
counter unwarranted impacts from over-the-counter markets on commodity exchanges.
Therefore, regulators should be enabled to intervene when swap dealer positions exceed
speculative position limits and may represent “excessive speculation”;
• Another key regulatory aspect entails extending the product coverage of detailed position reports
of United States-based commodity exchanges and requiring non-United States exchanges that
trade look-alike contracts to collect similar data. Stepped-up authority would allow regulators to
prevent bubble-creating trading behavior from having adverse consequences for the functioning
of commodity futures trading;
 • Renewed efforts are needed to design a global institutional arrangement supported by all
concerned nations, consisting of a minimum physical grain reserve (to stabilize markets and to
respond to emergency cases and humanitarian crises) as well as an intervention mechanism.
Intervention in the futures markets should be envisaged when a competent global institution
considers market prices to differ significantly from an estimated dynamic price band based on
market fundamentals. The global mechanism should be able to bet against the positions of hedge
funds and other big market participants, and would assume the role of “market maker”.

In a globalized economy, interventions in financial markets call for cooperation and coordination of
national institutions, and for specialized institutions with a multilateral mandate to oversee national
action. In the midst of the crisis, this is even more important than in normal times. The tendency of many
Governments to entrust to financial markets again the role of judge or jury in the reform process – and,
indeed, over the fate of whole nations – would seem inappropriate. It is indispensable to stabilize
exchange rates by direct and coordinated government intervention, supported by multilateral oversight,
instead of letting the market find the bottom line and trying to “convince” financial market participants of
the “credibility of policies” in the depreciating country, which typically involves pro-cyclical policies
such as public expenditure cuts or interest rate hikes. The problems of excessive speculative financial
activity have to be tackled in an integrated fashion. For example, dealing only with the national aspects of
re-regulation to prevent a recurrence of housing bubbles and the creation of related risky financial
instruments assets would only intensify speculation in other areas such as stock markets. Preventing
currency speculation through a new global monetary system with automatically adjusted exchange rates
might redirect the speculation searching for quick gains towards commodities futures markets and
increase volatility there. The same is true for regional success in fighting speculation, which might put
other regions in the spotlight of speculators. Nothing short of closing down the big casino will provide a
lasting solution.

International restructuring Strategy

Roland Berger (Strategy Consultants)

> During the crisis:

– Liquidity situation was critical for 40% of companies – Liquidity was
protected in the crisis predominantly by means of operational actions
– Focus on cost reduction – In total, personnel costs were cut by an average of
9%worldwide

> After the crisis:

– Companies view the worst of the global crisis as over and expect to see a
market improvement from the middle of 2010 – But there is still the burden of
rising unemployment in the short term

– 71% think that Asia will benefit most from the growth – 69% intend to focus
on their core business during the upturn, financing this with their own money
– 75% plan to conduct more growth and sales initiatives – Fairly low focus on
cost cutting in the future
Lessons learned from the crisis
1. INCREASE LIQUIDITY BUFFERS
An economic downturn can affect liquidity sooner than you think
> Create higher minimum liquidity reserves
> Optimize working capital continuously to cope with any future crises

2. ENSURE A COMFORTABLE EQUITY RATIO

The slump in revenues during the crisis hit equity sharply in many companies
> Reduce dependency on borrowing (i.e. leverage) by increasing the level of equity
> Contract the balance sheet, e.g. by making use of alternative forms of financing (e.g.
factoring) and selling off non-essential assets

3. ENSURE FLEXIBLE COST STRUCTURES

Prepare cost structures for any possible decline in business volumes
> Create variable cost structures (especially in personnel)
> Introduce additional reporting/early-warning systems

4. PREPARE FOR FUTURE GROWTH

Establish a basis for future growth in good time
> Don't make future growth impossible when cutting costs
> Plan growth and sales initiatives in parallel with cost actions
> Exploit competitors' weaknesses during the crisis
 Literature Review

Introduction
Over the past quarter century, American economists and policymakers have been very active in
providing policy advice to other countries about how to avoid and/or manage financial crises. In
many cases the essence of the advice was ‘you should be more like us.’ Suddenly, the United
States has been hit by its own financial crisis – one that is extraordinary in both its breadth and
severity. While prior financial panics in individual countries or regions have involved output
declines of equal or greater magnitude, the global dimensions of the current crisis are
unprecedented. It began in the United States, but has now spread to the furthest limits of the
world economy.

Financial crises occur with surprising frequency—in every decade in the past century there has
been at least one big shock to a major economy’s financial system. Judging from that history, the
current crisis will probably rank among the largest, and we face the prospect of a severe, painful
recession. The global economic crisis, which first emerged as a financial crisis in one country,
has now fully installed itself with no bottom yet in sight. The world economy is in a deep
recession, and the danger of falling into a deflationary trap cannot be dismissed for many
important countries.

The financial crisis that began in 2007 spread and gathered intensity in 2008. By early 2009, the
financial system and the global economy appeared to be locked in a descending spiral. The
Emergency Economic Stabilization Act (EESA) became law on October 3, 2008. Intended to
restore stability to the U.S. financial system, the act created a Troubled Assets Relief Program
(TARP).

TARP included two primary programs: a troubled asset purchase program and a troubled
asset insurance program. This report briefly introduces characteristics of current financial
instability. It also outlines the EESA legislation, the steps that Treasury has taken to implement
EESA, Next, the report provides an in-depth analysis of financial instability, including potential
causes of instability in general, and how it may spill over into the broader economy. This report
assesses the causes of this period of financial instability and provides the guide to the victims of
this crisis how to back on track. What needs to be done by the managers and on which area they
need to monitor critically.

Sources of Recent Market Turmoil

Although the prior section addressed financial market problems in general terms, this section discusses
problems specific to the current episode of financial turmoil. The initial spark for the financial turmoil is
generally agreed to be the increase in defaults among subprime mortgage borrowers and the loss of
liquidity of securities backed by mortgage loans. Since August 2007, financial firms have suffered
repeated problems in disposing of “toxic” assets, rolling over their own debt, identifying the relative
financial health of potential trading partners, and recapitalizing their balance sheets.35 The primary tools
of the Federal Reserve address liquidity, but financial firms are also experiencing capital adequacy
problems. For Fannie Mae and Freddie Mac, the Federal Housing Finance Agency (FHFA, formerly
OFHEO) and Treasury helped with both liquidity and capital adequacy for institutions the government
deems essential.36 Some argue that the apparent inconsistency between aid for Bear Stearns, no aid for
Lehman Brothers, and then the subsequent rescue of AIG increased rather than decreased uncertainty. At
any rate, credit markets suffered a near collapse in the days after the Lehman Brothers and AIG episodes.

Expectations, Mortgage Defaults, and Asset Prices

If investors expect high default rates by borrowers then prices might adjust to compensate for increased
losses; therefore, high default rates by themselves do not necessarily lead to financial market turmoil as
long as prices reflect the elevated risk. The rapid rate of increase in defaults on subprime mortgages,
however, was unexpected by many investors in global mortgage-backed securities markets. 37 During the
early stages of the mortgage market turmoil, some believed that it was largely a subprime problem caused
by predatory practices of unregulated lenders. Others argued that there were more general problems in
mortgage markets, both prime and subprime, that had encouraged the use of nontraditional mortgage
products to speculate on house price appreciation.39 If the only problem was wrong estimates of default
rates then financial markets might be expected to restore stability once higher risk levels are incorporated
in prices. Unfortunately, this has not as yet occurred, perhaps in part because there are characteristics of
housing markets that tend to reinforce downward price pressures, which also tend to increase default
rates.

Liquidity and Uncertainty

Loss of liquidity has been one of several problems in financial markets since the beginning of what
originally became known as the subprime crisis. Liquidity refers to the ability to sell an asset quickly
without suffering a significant price reduction—cash is typically the most liquid asset. A firm is liquid if
it has a significant portion of its assets in liquid form or can easily access debt markets to acquire liquid
assets as needed. A firm is solvent if the value of its assets is greater than the value of its liabilities. An
insolvent firm can be in trouble even if all of its assets are perfectly liquid, such as in cash. When
mortgage-related securities held by investment banks and other financial firms suffered higher than
expected default rates, the MBS lost their liquidity in part because potential buyers were uncertain as to
which securities contained the loans that were unlikely to perform. Complex accounting rules which
allowed certain assets to be held off balance sheet made the uncertainty worse, and many mortgage-
related securities became illiquid.

Capital Adequacy and Leverage

Efforts to restore liquidity do not necessarily address capital adequacy or solvency problems. A relatively
small drop in the market value of a firm’s assets can cause significant capital reduction if the firm is
highly leveraged. Leverage refers to the ratio of a firm’s equity capital to its other assets. The greater this
ratio the more vulnerable the firm is to falling asset prices. If a firm is leveraged 10:1 and it has $100 in
assets then it has $10 in equity capital and $90 in liabilities. In this case, a 5% drop in the value of the
firm’s assets would reduce assets to $95 (results from a $5 loss). Because assets equal liabilities plus
owners equity, and liabilities have not changed, the $5 loss comes out of equity capital. The firms equity
would drop from $10 to $5, still solvent in this example. If the firm had been leveraged 25:1 instead of
10:1, then the firm would start with $100 in assets, $96 in liabilities, and $4 in owner’s equity. The same
5% drop in asset values would completely wipe out owner’s equity and cause the firm to be insolvent (-$1
equity). A key principle of financial markets is that highly leveraged firms can become insolvent for
relatively small decreases in asset values; therefore, the damage to the financial system from
nonperforming loans can be several times the increase in default rates.
 A number of factors contributed to the increase in leverage in recent years, and the process of reducing
leverage may be difficult. One factor that contributed to the increase in leverage during 2002-2005 was
low interest rates across the globe, which made it very easy to use short-term debt to finance risky
activities. Another factor was the increased use of structured finance (securitization), which allowed banks
and other loan originators to move assets off of their balance sheets even though they were still exposed
to some risk if the loans failed to perform as expected. A third factor contributing to leverage was the use
of complex financial derivatives, which had the potential to reduce financial risks but also had the
potential to increase financial risk.

Too Complex to Fail?

Complex financial derivatives have been characterized by some observers as financial weapons of mass
destruction. A financial derivative is a contract in which two (or more) parties agree to a payment if a
referenced financial instrument changes price or otherwise satisfies conditions set in the contract.
Examples of financial derivatives include interest rate swaps and foreign exchange swaps that help firms
that are exposed to interest rate risk or exchange rate risk hedge against unexpected market events. The
contracts are typically tradable, which has benefits for the market as a whole as well as for the two firms
entering into the contract. The ability to trade the derivatives grants the two parties a more liquid asset.
The ability to trade the derivatives also provides information to the market as a whole because the
observed price of the contracts is a clue to market expectations about the future movements of interest
rates, exchange rates, etc. A cost to this increased liquidity is that linkages among firms through the
derivative contracts can become very complex and it may become difficult for parties to assess whether
their counterparties can actually honor all of their derivative contracts.
Causes of the Financial Crisis

Cause Argument Rejoinder

Against a backdrop of abundant credit, low

interest rates & rising house prices, lending Imprudent lending certainly played a role, but subprime loans (about $1 - 1.5
standards were relaxed to the point that many trillion currently outstanding) were a relatively small part of the overall U.S.
Imprudent Mortgage Lending
people were able to buy houses even they mortgage market (about $11 trillion) and of total credit market debt
couldn't afford. When prices began to fall and outstanding (about $50 trillion).
loans started going bad, there was severe
shock to the financial system

With its easy money policies, the Federal

It is difficult to identify a bubble until it bursts and FED actions to suppress
Reserve allowed housing prices to rise to
Housing Bubble the bubble may do more damage to the economy than waiting and responding
unsustainable levels. The crisis was triggered
to the effects the bubble bursting.
by the bubble bursting, as it was bound to do.

Global financial flows have been

characterized in recent years by an
unsustainable pattern: some countries (China, None of the adjustments that would reverse the fundamental imbalances has
Japan, and Germany) run large surpluses yet occurred. That is, there has not been a sharp fall in the dollar’s exchange
Global Imbalances every year, while others (like the U.S and value, and U.S. deficits persist.
U.K.) run deficits. The U.S. external deficits
have been mirrored by internal deficits in the
household and government sectors. U.S.
borrowing cannot continue indefinitely; the
resulting stress underlies current financial
disruptions.

Securitization fostered the “originate-to-

distribute” model, which reduced lenders’
incentives to be prudent, especially in the face Mortgage loans that were not securitized, but kept on the originating lender’s
of vast investor demand for subprime loans books, have also done poorly.
Securitization
packaged as AAA bonds. Ownership of
mortgage-backed securities was widely
dispersed, causing repercussions throughout
the global system when subprime loans went
bad in 2007.
 “Throughout the housing finance value chain,
many participants contributed to the creation
of bad mortgages and the selling of bad
securities, apparently feeling secure that they
would not be
held accountable for their actions. A lender
could sell exotic mortgages to home-owners,
apparently without fear of repercussions if
those mortgages failed. Similarly, a trader
could sell toxic securities to investors, Many contractual arrangements did provide recourse against sellers or issuers
Lack of Transparency and apparently without fear of personal of bad mortgages or related securities. Many non-bank mortgage lenders
Accountability in Mortgage responsibility if those contracts failed. And so failed because they were forced to take back loans that defaulted, and many
Finance it was for brokers, realtors, individuals in lawsuits have been filed against MBS issuers and others.
rating agencies, and other market participants,
each maximizing his or her own gain and
passing problems on down the line until the
system itself collapsed. Because of the lack of
participant accountability, the originate-
todistribute model of mortgage finance, with
its once great promise of managing risk,
became itself a massive generator of risk.”

The credit rating agencies gave AAA ratings

to numerous issues of subprime mortgage-
backed securities, many of which were
subsequently downgraded to junk status.
Critics cite poor economic models, conflicts All market participants underestimated risk, not just the rating agencies.
of interest, and lack of effective regulation as Purchasers of MBS were mainly sophisticated institutional investors, who
Rating Agencies reasons for the rating agencies’ failure. should have done their own due diligence investigations into the quality of
Another factor is the market’s excessive the instruments.
reliance on ratings, which has been reinforced
by numerous laws and regulations that use
ratings as a criterion for permissible
investments or as a factor in required capital
levels.

FASB standards require institutions to report

the fair (or current market) value of securities
they hold. Critics of the rule argue that this Many view uncertainty regarding financial institutions’ true condition as key
forces banks to recognize losses based on to the crisis. If accounting standards—however imperfect—are relaxed, fears
Mark-to-market Accounting “fire sale” prices that prevail in distressed that published balance sheets are unreliable will grow.
markets, prices believed to be below long-
term fundamental values. Those losses
undermine market confidence and exacerbate
banking system problems. Some propose
suspending mark-to-market; EESA requires a
study of its impact.
Proposing ways to fix the Crisis
• If you can’t survive hard times, sell out early. Once you are in financial distress, you will
have no bargaining power at all.
• In hard times, save the core at the expense of the periphery. When times improve,
recapture the periphery if it is still worthwhile.
• If hard times have a good side, it’s the pressure to cut expenses and find new efficiencies.
Cuts and changes that raised interpersonal hackles in good times can be made in hard
ones.
• Use hard times to concentrate on and strengthen your competitive advantage. If you are
confused about this concept, hard times will clarify it. Competitive advantage has two
branches, both growing from the same root. You have a competitive advantage when you
can take business away from another company at a profit and when your cash costs of
doing business are low enough that you can survive in hard times.
• Take advantage of hard times to buy the assets of distressed competitors at bargain
basement prices. The best assets are competitive advantages unwisely encumbered with
debt and clutter.
• Renegotiate with your vendors and suppliers.
• Focus on the employees and communities you will keep through the hard times. Good
relations with people you have retained and helped will be repaid many times over when
the good times return.
• Revise Basel II’s Three Pillars, don’t focus solely on pillar one, three pillars are
minimum capital requirement, supervisory review of capital adequacy and market
discipline.
• Create Comprehensive Regulation: The new regulations should be comprehensive,
covering all activities, instruments, markets, and institutions, including off-balance sheet
items, hedge funds, and off shore centers and tax havens.
• Reduce Market Risk: The purpose is to protect the core from other less regulated sectors
of the financial system that might still exist and where the informational problems
continue to prevail.

• Revise Basel II’s Three Pillars

Reform should address all “Three Pillars” of the Basel Committee’s regulations and not
focus solely on pillar one. The three pillars are: minimum capital requirements,
supervisory review of capital adequacy and market discipline. Within the Basel II
framework, the emphasis is placed on the capital requirement that relies on banks’ own
internal risk management system. Market disclosure and discipline comes next. Also
under Basel II, the authorities de-emphasize the traditional activities of regulators and
supervisors, who enforce externally determined and sometimes non-market-based rules of
regulation. The eight percent capital requirement is a minimum capital ratio. A bank’s
supervisor may require it to maintain a higher one. But the authorities may have no need
to enforce any requirement that a bank have a higher capital ratio, due to market
discipline. Since a bank’s capital ratio is made public, it functions as a quick and easy
measure of the bank’s soundness. Banks with high capital ratios have easy access to both
capital and credit. The markets punish banks with low capital ratios. This may well seem
a sensible thing to do if the purpose is to regulate an individual bank, but the effects are
different in practice and in the aggregate: this package of policies accentuates rather than
dampens the business cycle. It is easy to see why. The problem is not simply that a
 bank’s capital normally rises during a boom and falls during a crisis. The problem is that
the capital requirements are risk-weighted. The risk weights are functions of current and
recent prices, and are thus inherently counter-cyclical: the risk measures fall during the
boom and rise during the bust. Then there is the problem of Basel II’s effect on the
diversity of investors’ opinions: if every investor is using the same risk measurement and
management system, the resultant lack of disagreement will make the trading of that risk
impossible. The market discipline that this system encourages is loose during the boom
and harsh during the bust. Banks that are doing well, that is banks with rising capital and
profitable investments that are seemingly less risky are given more capital to spend.
Banks in trouble, that is, banks with falling capital and riskier and losing investments, are
starved. The effect of each bank acting in the same way is first expansionary then
contractionary to an extreme degree. Everyone either increases or slows his lending at the
same time. Individual banks, those whose capital ratios are known to be rising or falling
the most rapidly, will be rewarded most and punished worst. Two important
countercyclical reforms should be introduced either to replace or to counteract the
existing capital requirement’s pro-cyclicality. The capital requirements themselves could
be reformed to make them counter-cyclical. Provisioning should be used as a
countercyclical policy tool. Banks should make the additions to their loan loss reserves
when they make their loans. Margin requirements should be used proactively. The
objective of these and similar measures is to prevent the bust by preventing the boom
from getting out of hand.

• Create Comprehensive Regulation

The new regulations should be comprehensive, covering all activities, instruments,

markets, and institutions, including off-balance sheet items, hedge funds, and off shore
centers and tax havens. Otherwise, a “shadow finance system” makes it impossible to
avoid the over-leveraging and regulatory arbitrage that contributed to the current crisis.
Every kind of banking and financial activity needs to be monitored, both the underlying
and the derivative security brought under review, and exchange-traded as well as overthe-
counter securities brought under control. Trading firms, insurance companies and pension
and mutual funds must come under review. A world financial authority or global
regulator to complement a reformed IMF, reconfigured as a central bank of central banks,
would be needed to develop and then implement the needed regulatory reforms. Simply
put, the domain of the regulator should be the same as the domain of the market.

• Adopt Liquidity Measures

Serious flaws exist in the short-term money markets in which financial and nonfinancial
institutions raise funds to finance their investments and other longer term activities.
Every kind of institution, market, and financial system has been adversely affected by the
crisis, but the market that has been affected the worst lies at the very center of the
international economy: the interbank market. Central banks everywhere have taken
measures to make the term interbank market liquid again, but so far without success. The
reasons for these failures are not clearly understood, nor is it apparent why the interbank
market has been so severely affected. The short-term money markets are in urgent need
of reform.
• Reduce Market Risk

Assuming that the market risk cannot be removed completely from the financial system,
measures must be taken to place a ring around the system’s core banking and financial
institutions. The purpose is to protect the core from other less regulated sectors of the
financial system that might still exist and where the informational problems continue to
prevail. The problem is to control leveraging – the mobilization of the monetary system
for speculative purpose – and thus to prevent the leveraged money from collapsing during
a financial crisis back into its monetary base, with inevitable disruptive effects on the use
of money as a means of payment. Strong regulation, coupled with generous lender-oflast-
resort lending when needed, are clearly part of the long term solution.

• Adopt Fiscal Stimulus Packages

Fiscal stimulus is urgently needed to revive the underlying real economy as monetary
policy is clearly caught up in what even Keynes would call a “liquidity trap.” A large,
rapid, and internationally coordinated fiscal expansion is needed to stimulate world
demand, and it is needed immediately. This could and perhaps should be accompanied by
a recycling of China’s, Japan’s and other countries’ large external reserves – possibly
through a network of regional development banks – to emerging market and developing
countries in need of additional financing.