KEY POINTS:
The Global Financial Stability Report issued by the International Monetary Fund this month makes for sober reading.
When it estimated sub-prime related loan write-offs and losses on loan-backed securities at US$945 billion ($1.5 trillion) back in April the IMF was criticised for being pessimistic.
The latest report has raised these estimates to US$1.4 trillion, equivalent to 9.8 per cent of US gross domestic product.
While this latter figure illustrated the magnitude of the sub-prime crisis, the IMF was more concerned with managing the ongoing deleveraging of a bloated global financial system in an orderly fashion.
In its view, this process became very "disorderly" following the decision by the US Treasury to let Lehman Brothers file for bankruptcy on September 15.
This event sparked a run on money market funds that held Lehman debt, cutting off the flow of funds into the commercial paper market and driving up wholesale interest rates, particularly for US dollar funding.
It also shattered investor faith in the "too big to fail" argument and sent the prices of bank stocks tumbling as nervous investors speculated over the identity of the next casualty.
The IMF report identified three interrelated areas that required urgent action.
First, bank capital levels badly depleted by loan write-downs and losses on loan-related assets had to be rebuilt.
The IMF estimated that banks would need US$675 billion more in new capital to strengthen balance sheets and fund modest growth in lending over the medium term.
Second, the troubled assets on bank balance sheets had to be removed to provide potential lenders to banks with more certainty about the health of the banks to whom they were lending.
It was critical that banks not be forced into liquidating these assets at fire-sale prices since this would only increase the amount of fresh capital banks required.
Third, wholesale markets had to be thawed, and quickly, to restore the flow of funding for banks and to prevent further damage to economic activity at a time when many Western economies were on the point of sliding into recession.
Interbank markets had seized up because banks were no longer prepared to lend to other banks on an unsecured basis.
Similar concerns had seen the cash-rich money market funds desert the market for commercial paper issued by banks.
The report called for concerted action by the governments of the leading industrial nations.
Policymakers and politicians in these countries had also realised that the worsening crisis could not be resolved without immediate and decisive intervention by the governments.
The recapitalisation of banks would require taxpayer support since existing shareholders had little incentive to contribute equity that simply shored up the position of depositors and other debt holders.
Taxpayers would also need to fund the purchase of distressed assets sitting on bank balance sheets.
Lastly, some form of government guarantee on bank borrowing would be required to thaw the wholesale markets.
The IMF also suggested that central banks could play a greater role in alleviating funding pressures in the wholesale markets.
The last two weeks have witnessed decisive action to address the three areas of capital, assets and liquidity.
The resulting restoration of confidence in the banking system and the influx of liquidity from central banks have seen bank stock prices stabilise and interbank rates begin to decline.
The headline interbank rate, three-month US dollar Libor, fell 0.4 per cent to 4.42 per cent last week, the first weekly decline since mid-September.
The rate fell 0.36 per cent on Monday to 4.06 per cent. The prices for the near to maturity Eurodollar futures contracts traded on the Chicago Mercantile Exchange show that the market expects these declines to continue.
Nearly six weeks ago, on the Friday before Lehman Brothers filed for bankruptcy, three-month US dollar Libor stood at 2.81 per cent.
Commentators are now cautiously optimistic that the drastic steps have succeeded in containing the immediate crisis.
The major problem now is the potential stress on the global financial system arising from the looming economic recession.
* Dr Russell Poskitt, associate professor, department of accounting and finance, University of Auckland Business School.
