RSS FeedBy M. Isi Eromosele
During the past three years, several global finance reform proposals have been floated about by national and international regulatory bodies. These have tended to include calls for banks and investment banks to raise capital to offset losses they may incur on write-downs on mortgages, mortgage-backed securities and other assets.
Capital has come to be viewed as the sole cushion for global financial institutions and their progressively shrinking capital base is increasingly seen as a threat to systemic solvency.
It should be noted that this ongoing pressure on capital is impeding efforts to revive credit flows and maintain viable economic activity.
The seriousness of the threat of global institutional solvency has raised the issue of whether the U.S. Federal Reserve and other global Central Banks have the capability to diffuse the credit crunch and stem the decline of asset prices. For many financial institutions in the United States, the problem has shifted from that of a liquidity crisis to a solvency crisis.
While a continuation of liquidity support is necessary, it is of limited value, especially in terms of ending the crisis or moderating its current negative impact on the global economy. Increasing, solutions have veered towards proposals that call for government intervention to protect the solvency of selected systematic important institutions.
Given the sizable shift in savings and investment flows from banks to institutional investors, the transmission line for both regulatory and monetary policy initiatives must be extended to reach all the segments of the global financial system.
This type of reform should be implemented to help restore as well as bolster global financial stability. It should include the following key issues:
The Role Of Capital In A Market-Based System
The balance sheets of depository financial institutions have always served as the basis for assessing the role that capital plays in protecting the soundness of the global financial system.
However, it should be noted that prior to 1983, there was no statutory regulations in the United States mandating banks to hold a specific amount as reserve capital. Asset and capital requirements tended to be ignored in other countries as well. This trend was reversed in the early 1980s, with the threat of default and the proliferation of non-performing loans on developing country debts.
Rules governing capital adequacy for banks have not provided the systematic protection that was expected. The resulting threats to the solvency of systematically important non-depository institutions have made clear that the focus on banks’ capital position is incomplete. The role of capital in a transformed market-based system is a parallel concern.
There is an acute need to reassess the role of capital in a systematic context and ensure that countercyclical capital requirements are developed that will bolster the soundness of all global financial institutions and activities.
Maintaining Liquidity In A Market-Based System
Since capital is a scarce resource and one that is automatically depleted when losses are written off, liquidity requirements were used by global Central Banks and regulators as a vital tool to protect capital in the period before deregulation was enacted.
The Federal Reserve’s recent call for key financial institutions and investment houses to shore up their balance sheets with more liquid assets clearly shows the belated recognition that capital alone is an insufficient cushion against the threat of insolvency.
A cushion of reserve balances owned by financial institutions but held by a Central Bank would be a far more effective way to alleviate the ongoing credit crunch. The soundness of payments among financial institutions made by transferring reserve balances would not be questioned.
Additionally, reserve balances would retain their face value, despite the erosion of asset prices. As such, an established pool of established financial sector reserves held by the Central Banks would act as a more effective liquidity buffer.
There is clearly a vital link between liquidity and solvency. Liquidity protects solvency and global financial stability will require reforms that include comprehensive, countercyclical regulatory and monetary strategies.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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