CIA-In+desperate+need+of+repair

=In desperate need of repair= BRIAN MILNER AND BARRIE MCKENNA AND HEATHER SCOFFIELD From Saturday's Globe and Mail November 14, 2008 at 8:58 PM EST

Brazil's populist President, Luiz Inacio Lula da Silva, took the podium in Sao Paulo last weekend to deliver a blunt speech to 20 global powers, essentially saying: You started it. Now fix it. “No country is safe from the financial crisis. We are all being affected by the problems that started in the advanced countries,” Mr. da Silva told finance ministers and central bankers of the G20 countries. The chastened ministers had no choice but to sit there and agree. And then they got to work. They put their stamp of approval on what is becoming a consensus about what is needed to put the global economy and financial markets back on track. On Saturday, the G20 political leaders will sanction their approach. They want the leading developed countries to devise more ways to restore credit markets, keep slashing interest rates to stimulate growth and pour much more government money into fiscal stimulus packages.

All of these are emergency measures that are indeed critical. But they amount to calling out the fire brigade to put out a kitchen blaze in a shoddily maintained mansion. Once the flames are doused, the owners will have to commit to an extensive and costly rebuilding of everything from the cracked foundation, the crumbling walls and the outmoded wiring and plumbing to the badly leaking roof. And that's on top of the structural damage wrought by the hurricane-force financial storms. The best we can hope for out of the unprecedented G20 gathering are some cosmetic improvements, a professed commitment to working together and lots of talk about serious reforms down the road. Here are key trouble spots that will have to be addressed – some sooner than others, but all of them eventually – to reduce the likelihood that the global financial system will fall prey to another “once-in-a-lifetime” catastrophe any time soon. As the world slides into recession, governments reach for the traditional tools aimed at handing out enough money to get consumers buying and companies investing. The list of countries that have already announced stimulus packages is getting longer by the day, partly in response to pressure from world leaders. But the planned tax cuts and juiced spending are not nearly enough to reverse the slide. What's needed are extra outlays worth between 5 and 8 per cent of a country's gross domestic product over the next 18 months, preferably all at once in a co-ordinated Big Bang, argues Larry Hatheway, chief economist at UBS. That would amount to about $3-trillion (U.S.) injected into a global economy worth $60-trillion, if everyone got on board. China and Europe, in particular, have a lot more capacity to spend. But only those countries that can truly afford it should go large – namely those running surpluses or small deficits, carrying low debt or with current account surpluses. Otherwise, excessive spending will just create a debt crisis of its own. The risk is that the rescue packages won't provide the necessary spur to spending or stem the bleeding by key industries. If consumers save their money instead of spending it and big corporations start laying off huge swaths of people, the banks will get nervous again, and credit could easily seize up once more – starting a vicious circle. But if the debt-financed stimulus ends up being too big, governments with weaker balance sheets will face a loss of confidence in their currency and a flight of capital.
 * Fiscal stimulus (the foundation)**

//Chances of more stimulus:// Certain. //Chances of stimulus being big enough:// Slim.

It's rare – and alarming – when central banks act in tandem to slash interest rates. They did it in early October. And since then, the world's most powerful central banks have either continued to cut or have sent clear signals that more reductions are in store. In some countries, rates are so low now that, once inflation is taken into account, the real cost of capital is zero, or even less. But the cuts must continue, policy makers agree, especially now that commodity prices have fallen so much that the inflationary threat is quickly vanishing. The aim is to make it affordable for households and corporations to borrow money, so they can invest and spend and rejuvenate the economy. By working together at the same time, central banks limit the chances of currency speculators playing one regime off another. And they also limit the amount of “leakage” that comes from lower rates inadvertently spurring on consumers to buy imports. By doing it all at once, the import indulgence in one country becomes the export selling of another, and the two forces offset each other – at least in theory. The risk here is that rates become so low central banks have no further room to cut. //Chances of more rate cuts:// Certain. //Chances of more co-ordinated rate cuts:// Less certain
 * Rate cuts (the water supply)**

By all accounts, attempts to manage the financial crisis have been nothing short of revolutionary. Central banks have creatively used their balance sheets to flood money markets with any kind of credit they need, and as collateral, they are taking just about anything in return. They have guaranteed loans between commercial banks, guaranteed huge amounts of bank deposits and changed accounting standards so that banks can spread out their losses over time. In the United States and in Europe, governments have recapitalized banks, bailing them out by buying their shares or making other arrangements to support failing balance sheets with taxpayers' money. The U.S. Federal Reserve has started buying commercial paper. For the first time, the Fed has set up currency swap lines with key emerging markets. And the International Monetary Fund is lending short-term money too. Now, though, the capital is pooling on the balance sheets of financial institutions, which are focused on shrinking credit, not expanding it. That's partly because they are afraid their customers won't pay them back. As a result, the cost of capital is too high, and its availability in the marketplace is scarce. Governments need to break the logjam. Guarantees of commercial loans should eventually do this, says Bank of Canada Governor Mark Carney. Officials are also arm-twisting banks to lend again – evident in the messages of Canada's Jim Flaherty and Washington's Henry Paulson this week. And Mr. Paulson's intentions of taking larger equity stakes in banks may scare them enough that they could resume lending, to keep him off their backs and out of their books. Analysts say the confidence to lend will return when the U.S. housing market hits bottom. Then, housing will stop hammering U.S. growth, banks will see some benefits to issuing mortgages, and the money will start flowing. But no one knows where the bottom lies or how soon it will be reached. //– Chances of ending bank hoarding:// Certain. //– Chances of ending it soon:// Slightly better than slim.
 * The return of lending (the pipes)**

If there's one thing this crisis has shown it's that no one is watching over the global financial system – not the Group of Seven, not the world's big central banks and certainly not bank CEOs. That must change. And there's only one institution with the expertise and the resources to do it – the International Monetary Fund. Grey, faceless and increasingly irrelevant in recent years, the Washington-based agency is needed more than ever. Just not the IMF of today. The fund has to be bigger, tougher and a lot more democratic. The IMF is one of the original institutions set up at the Bretton Woods conference of 1944, which paved the way for the modern era of global finance. It was designed to provide financial insurance, a lender of last resort. Unfortunately, it hasn't kept pace with rocketing cross-border financial flows, and countries know it. Without adequate insurance, countries such as Brazil or South Korea must essentially self-insure, hoarding U.S. dollar reserves for that rainy day, and inadvertently exacerbating the imbalances that helped get us into this mess. The fund has a war chest of roughly $200-billion. It may need several trillion dollars to bail out troubled economies. The fund also must have teeth. The IMF needs the resources to monitor risks to the global financial system and the power to stop crises before they happen. In the past, its power to influence has come as a condition of its cash. The IMF should join forces with a loose group of international regulators, known as the Financial Stability Forum, to set tough standards for accounting, banking regulation and risk. One of the reasons the IMF has lost stature is that it represents the world as it was in 1944, not 2008. The European Union controls 32 per cent of its votes. The U.S. has 17 per cent, giving a virtual veto over all decisions, which require an 85 per cent supermajority. Add in Japan and Canada, and it's clear who is in control. China, by comparison, has 3.5 per cent of the votes. Without important financial players such as China, Brazil and India fully on board, the fund will never have the buy-in to be a tough cop. //Chances of this happening:// More likely if crisis worsens.
 * More oversight required (the roof)**

If you think the world has problems now, just wait until the global slump stirs the inevitable protectionist passions. The infamous Smoot-Hawley tariff in the U.S. helped plunge the world into the Great Depression of the 1930s. Think it can't happen again? Don't be so sure. China recently adopted new export subsidies – not helpful for a country with the world's largest trade surplus. Meanwhile, Washington is under intense pressure to bail out the Detroit auto makers, putting everyone else at a disadvantage, including Canadian plants, as well as Japanese and South Korean car makers. Faced with a deep recession, U.S. protectionist tendencies are likely to grow stronger, particularly with the Democrats firmly in charge of the White House and both houses of Congress. And other countries would respond in kind. It won't be easy, but this crisis should be the impetus needed to re-energize the Doha round of global free-trade talks. Trade flows are already falling as the world slips into recession. A 23-country survey released this week shows that a majority of people now favour protectionist measures and fewer than half see globalization as being in their families' interests. The chasm between the developed and developing worlds that has hindered reform at the IMF has also stalled work on a deal to lower barriers in farm goods and services. Here's an idea: Throw sovereign wealth funds (SWFs) and currencies into the trade negotiating mix. Get China to un-peg its currency from the U.S. dollar in exchange for a much greater say in how the global financial system is run, and provide clear and rational investment rules for its SWFs. That would go a long way to unwinding the massive trade and financial imbalances that have unhinged the global economy. //Chances of this happening:// Slim
 * Spur trade talks (the doors)**

Two descriptive words come to mind when conversations turn to derivatives – complex and opaque. The sheer complexity of many of these instruments is not the problem. But it does mean that the purchasers of the products too often have no idea exactly what they're buying or what the price should realistically be to take into account the associated risks. And the opacity makes it harder to get the answers. What regulators have to figure out is how best to protect buyers from themselves, as well as from salespeople who are less than candid about exactly what they are peddling. The simplest answer is to limit the types of derivatives that can be sold to different categories of investors. In other words, keep them plain vanilla for the less sophisticated people and provide better disclosure to the more experienced. The debate now is how best to go about imposing a regulatory regime on the $50-trillion-plus over-the-counter market. One solution is to move the whole business to futures exchanges, where every credit default swap would morph into a listed futures contract, and market forces would determine the price. The exchange model would also effectively restrict the role of the banks as middlemen in the transactions, which has come back to haunt their balance sheets. But as derivatives experts have pointed out, this is not as easy as it seems. And the drawbacks may well outweigh any advantages. Say two parties agree on a derivatives contract and then have to take it to an exchange. Instead of the two sides in the transaction holding risk on each other, that risk is transferred to the exchange, and it would have to be capitalized or at least guaranteed by very reputable sources. Then there is the question of how to mark the instrument to market. Simply putting the contract into the framework of an exchange doesn't eliminate either the opacity or the pricing problem. Also, exchange-trading has been tried before, without success. The investment banks did their best to thwart the exchange model, because of the huge profits they were reaping. They refused to be market makers and would not support the contracts that were listed. Why let customers see the actual pricing of a product, when you can charge whatever you think the market will bear? Besides profit concerns, the one-size-fits-all formula of exchanges has proved particularly ill-suited to the innovative world of derivatives, where custom design is a major attraction. A more popular solution is to set up a central clearing house, where every trade is registered and the pricing set. It would solve the problem of transparency, reduce risk, remove valuation differences, at least in theory, and make settlements easier when contract positions are closed out. The industry knows it faces genuine regulation and new operating rules, so its own preference – self-policing – is a dead issue.
 * Credit derivatives (the heat)**

//– Chances of major changes:// Certain. //– Chances of a turf war over who gets to do the regulating:// Probable.

Forget greed, arrogance, way too much leverage and the mispricing of risk. To hear financial services types tell it, the real reason for the current global mess is mark-to-market accounting. Because companies are required by the strict rules to price most assets at fair market value each quarter, banks, insurers and other intermediaries ended up with massive paper losses –and sharply reduced capital – when the U.S. subprime mortgage market collapsed, even though their own assets may still have been perfectly sound. Although it's a bit rich to be blaming accounting rules for a credit market disaster of their own making, they have a valid criticism. Why force an insurance company to value, say, a 15-year bond at its current distressed market price if it has no intention of disposing of it? Plainly, until they are actually put on the block, some assets should remain valued at their historic cost (with regular re-evaluations by the auditors), rather than marked down for a fire sale that isn't about to occur, or have their value determined by some model in cases where there is no market at all. But that doesn't mean tossing M2M on the scrap heap. It's an important tool for investors seeking an accurate assessment of a company's financial health. As Lynn Turner, former chief accountant of the U.S. Securities and Exchange Commission, told a congressional panel last month, allowing the reporting rule to be sidestepped would be “akin to a student asking for suspension of a report card when a failing grade is coming.” One intriguing solution would be to require M2M for any asset for which there is a ready market, and traditional accounting for long-term holdings for which there is no observable market – essentially two sets of books, but with full disclosure. Additionally, all financial institutions and hedge funds should be required to hold sufficient reserves to cover every loan, derivative and any other exotic instrument, with restrictions on their use of leverage.
 * Fair-value accounting (the windows)**

//– Chances of something happening:// Probable

Basel is used to being overlooked. Switzerland's second-largest city doesn't get the attention, or the visitors, that the larger financial centre of Zurich draws. But its strategic location on the Rhine River, where the borders of Germany and France meet, has made it a historic meeting place as far back as 1499 when the Basel Treaty was signed ending the Swabian War. Nearly five centuries later, in 1974, regulators and central bankers from Canada, the U.S., Japan and across Europe met there to consider some basic goals of bank supervision. In 1988, the committee agreed on the Basel Accord. The deal focused on higher capital ratios – a response to an emerging wave of global banks and the lessons learned from the U.S. savings-and-loan debacle. After five years of plodding work, the committee modernized its rules in 2004. Those rules, known as Basel II, are just now coming into force. And unfortunately, they're already badly out of date. The idea was good: Introduce modern risk management practices to devise rules that fit individual institutions. Basel II had three main principles: setting minimum capital requirements; getting banks to police their risk levels; and publishing their risk profiles. Basel II requires banks to use complex mathematical models to set capital levels, by using historical data to project future losses. The problem is that this system allows banks to keep levels low in good times and then forces them to raise capital in bad times, such as now, when it is a scarce commodity. The application of Basel II to investment banks had a particularly insidious effect. It allows banks to treat triple-A-rated mortgage-backed securities almost like cash. As a result, Wall Street took on way too much leverage. That didn't work out so well. The solution seems obvious: Scrap Basel II and adopt a more countercyclical model. Like a smart squirrel, store away cash when times are good so you can survive hard times like the winter of 2008-09. //– Chances of a new model:// Probable within five years.
 * Capital adequacy (the wiring)**

Once the immediate repairs have been made, financial institutions have been forced to write off all the garbage on their books and the mechanisms of global finance are functioning at something resembling normal again, it will be time to weigh far-reaching changes to the world's banking system. One idea, which would have been laughed out of the conference room just a few months ago, is to create a two-tiered banking system on a global scale. It would mean a return to the separation of commercial and investment banks, along the lines of the former U.S. system that was finally ditched in the 1990s after being circumvented for years, but with a few key differences. The commercial banks would be limited to traditional banking – taking deposits, making business and consumer loans, and writing mortgages, with basic money market, swap and foreign exchange functions. They would be highly regulated, fully covered by deposit insurance and loan guarantees and completely transparent in their activities. This would be the only part of a revamped global system that governments would take full responsibility for overseeing. The second tier would include investment banks, hedge funds and any other participant in the financial system whose primary business is making money in the markets. They would face minimal regulation, apart from what is applied to any companies that access the capital markets. They would thus be free to engage in any money-making scheme they chose, but there would be a couple of important caveats attached: Their size would be restricted, so they could never again become too big to fail and they would have no recourse to government bailouts if their business went sour. An alternative is to put everything in the brave new world of finance, no matter how complex, under tight government supervision. //- Chances of remaking financial system:// Don't hold your breath. //- Chances of heavier regulation:// Certain
 * A new banking order (the walls)**

The news is all about American and European governments buying stakes in their countries' banks, guaranteeing loans and offering a pile of supports for credit flows. But not every part of the world is thrilled about the return of statism in banking. Those countries who aren't as activist find that their banks are becoming less globally competitive. Some governments – especially emerging markets – don't have the deep pockets of the U.S., the U.K. and European Union, and can't afford to keep up with the subsidies. And some – notably Canada – don't think their banks need extreme bailouts. While the non-subsidizing governments tolerate the U.S. and European support for now, they're also anxious for the day when banks can compete globally on an even playing field. Canada and several emerging markets are pushing for an exit strategy that would unwind all the subsidies that have sprung up in recent months. They want fair competition to return as soon as possible. Canada doesn't have to worry much about undoing its own interventions, says Bank of Canada Governor Mark Carney, because many have time limits built in. Unwinding the measures needs to be done carefully. Moreover, government equity in banks can't simply be sold off quickly, especially if there is no obvious buyer willing to offer a good price. Loan guarantees have a built-in shelf life that can't be reneged upon. And central bank involvement in the credit markets can only be withdrawn gradually, after confidence returns.
 * The exit (the renovation)**