"A system that appeared resilient (and enormously profitable) in times of low volatility has proven brittle in the face of shocks."

Mark Carney with a good post in the FT:

"Our response to the financial crisis will be as important as the event itself. We can never eliminate financial crises, but we can reduce their likelihood and severity. By taking a macro-prudential approach to capital and committing to continuously open markets, we can both limit the downturn and build a more resilient financial system."

This sounds a lot like Prof. Mankiw's post.

"This crisis marks the reversal of a decades-long transition from a bank-dominated to a market-dominated financial system. The market-based model has the potential to price risk and to allocate capital more efficiently. In some cases, however, the development of markets ran well ahead of the supporting infrastructure. A system that appeared resilient (and enormously profitable) in times of low volatility has proven brittle in the face of shocks."

So we need to build resiliency into the now Market-Dominated Financial System. Is this Prof. Mankiw's robustness?

"In many parts of the world, market-based finance has weakened core financial institutions and put large non-bank financial sectors under great strain. Certain markets are now frozen. Consequently, there is a sudden re-emphasis on bank-based intermediation that has led to an urgent need for banks to raise very large amounts of capital. This threatens to intensify the global economic slowdown if not managed properly.

We must ensure that banks continue to lend. We must also ensure that core markets – such as interbank lending, commercial paper and repo markets for high-quality securities – are kept continuously open. There are two related strategies to achieve these imperatives."

If the banks do not do it, and it's an imperative, doesn't that mean that the government should do it? This looks like a rationale for a small national bank.

"The first is the action plan of the Group of Seven leading industrialised nations to make banks resilient so that they can resume their market-making roles. The G7 made a firm commitment that no systemically important institution will be allowed to fail and that sufficient capital – public and private – will be provided to restore confidence. In recent weeks, G7 governments have acted with bold measures to honour these principles. In tandem, central banks have fulfilled their commitments to “ensure that banks and other financial institutions have broad access to liquidity and funding”. The liquidity they provide to core institutions should cascade through the system to other market participants and, ultimately, through private credit creation, to the real economy."

I don't know how much firmer they could be, since they're throwing the kitchen sink at the problem. All they could do now is tattoo their commitment on all our bodies.

"The G7 action plan will work, but it will take time for capital and confidence to return. In those systems with weaker core financial institutions and larger shadow banking systems, the adjustment process could take longer, making it all the more important that financial guarantee programmes instituted in many countries are used to maximum effect. The explicit G7 commitments should secure cost-effective funding while the necessary capital increases are spread over time."

Keep it going.

"In parallel, policymakers must have the courage of their (new-found) macro-prudential convictions. In line with the G20 leaders’ call for regulators to mitigate pro-cyclicality in capital, we should not push capital standards up too high, too rapidly. Through-the-cycle capital means that capital ratios should fall in a downturn. Just as bad loans are made in good times, now is the time to finance business investment for the inevitable global recovery."

I'm fine with slowly but surely, but wonder if getting to higher capital levels sooner than later would help.

"The second strategy recognises that the transition towards a market-based financial system has increased the importance of core money markets. In economies with weak banks and large non-bank sectors, massive central bank liquidity is not yet cascading through the system. Non-bank participants – such as money market funds, pension funds and hedge funds – fear that liquidity may not be continuously available. Their fears will not fade without structural changes to markets."

We need to change markets.

"This is a situation where central banks should consider acting as market-makers of last resort by becoming a counterparty to a broad range of market participants. Some central banks are already acting as de facto central counterparties by taking in deposits from institutions with excess liquidity and providing it to those with deficient liquidity. Depending on the importance of non-bank participants to our core money markets, central banks should expand the range of our counterparties and the frequency of our interventions."

If so, then these institutions should obey stricter guidelines. I'm not sure about this one.

"In the medium term, we could adapt regulations and standards, for example, with higher capital requirements for securities that trade outside continuously open markets; and the application of fair-value accounting could be limited to those securities that trade on exchanges or in continuously open markets. If the central bank were the market-maker of last resort, it could reinforce such standards."

If the Central Bank is the last resort for any financial concern, it should be regulated with the taxpayer's interests in line.

"Behind these strategies is a single purpose: to rebuild the financial system on a network of continuously open markets so that credit again flows to the real economy – the industries that create the products, services and jobs that underpin our shared prosperity.

The writer is governor of the Bank of Canada. The piece was based on a speech to the UK-Canada Chamber of Commerce in London on 19 November"

I like Carney, and basically agree about the market-system approach, but I think that we should consider having a well regulated and government guaranteed part of the financial system, and a non-guaranteed part of the financial system which is supervised, but less regulated, and monitored for problems that can lead to a cascading effect.

The bottom line, of course, is that the government is the lender of last resort, and so how much risk are the taxpayers willing to accept under these conditions? Given the reality, they might demand a system more or less like Carney's, since this bailout has weakened the taste for another possible bailout.

"``The Fed is making dollars available to the central banks of these countries who are trying to meet the needs of their banking systems.''

We've discussed Swap lines to various smaller countries from the Fed in discussing:

Soros:
2) Swap lines from big countries to small countries ( Fine )

Sachs:
1) Big national banks extend swap lines to smaller country national banks. ( Fine ) See Brad Setser here.

From Bloomberg:

"Fed Opens Swaps With South Korea, Brazil, Mexico, Singapore

By Steve Matthews and William Sim

Oct. 30 (Bloomberg) -- The Federal Reserve agreed to provide $30 billion each to the central banks of Brazil, Mexico, South Korea and Singapore, expanding its effort to unfreeze money markets to emerging nations for the first time.

The Fed set up ``liquidity swap facilities with the central banks of these four large systemically important economies'' effective until April 30, the central bank said yesterday in a statement. The arrangements aim ``to mitigate the spread of difficulties in obtaining U.S. dollar funding.''

Fed Chairman Ben S. Bernanke is trying to prevent the global credit crisis from upending the financial markets and economies of developing countries, where currencies have plunged and government bond premiums have soared. The Fed yesterday cut its benchmark interest rate, followed by Hong Kong and Taiwan today."

Read the whole post.

I agree with this:

``We can't leave these other important countries out in the cold,'' said Edwin Truman, a senior fellow at the Peterson Institute for International Economics in Washington and former chief of the Fed's international-finance division. ``A global recession is being caused by the effects of seizing up of the financial system around the world.''

Countries listed:
South Korea
Brazil
Mexico
Singapore
New Zealand
Australia
Central European Bank

and a few others.

Also, Brad Setser:

"Today the Federal Reserve indicated that it would swap US dollars for Brazilian real, Korean won, Mexican pesos and Singapore dollars — effectively allowing a select group of emerging economies to borrow dollars on terms similar to those available to the G-10 economies. Or almost similar terms. The G-10 central banks can currently borrow dollars from the Fed without limit; the four selected emerging market central banks can only borrow $30 billion each. But $120 billion is real money — and if need be, the the size of these swap lines conceivably could be increased.

This move goes some way toward breaking down the line between the G-7 (really G-10) economies and emerging economies that emerged after the G-7 countries guaranteed that systemically important financial institutions in their economies wouldn’t be allowed to fail and the Fed expanded the scale of the swap lines available to European economies whose banks had a large need for dollars. "

More On The Implicit Assumptions

From Brad Setser:

“Prior to Lehman, there was an almost unshakable faith that the senior creditors and counterparties of large, systemically important financial institutions would not face the risk of outright default,” notes Neil McLeish, analyst at Morgan Stanley.”

Much of the infrastructure of modern finance in effect rested on an expectation of a government backstop for the creditors of large financial institutions – a backstop that allowed a broad set of institutions to borrow short-term at low rates despite holding large quantities opaque and hard to value assets on their balance sheets.

That observation has a number of implications, not the least that the leverage – and resulting capacity for outsized profits — of some parts of the financial sector was made possible by the expectation that the government would protect the key creditors of the financial system from losses.

Lehman’s default shattered this implicit guarantee. The end result likely will be a series of explicit guarantees – and a rather significant government recapitalization of the financial sector.

The G-7 didn’t agree on a detailed action plan, only general principles. But by tomorrow morning, national governments will likely have extended guarantees to an enormous share of the liabilities of the world’s “private” financial system. And other parts of the “private” financial system will no longer be in private hands.

Stunning."

Again, I've been saying this all along.

G-7 Finance Ministers and Central Bank Governors Plan of Action

Via Across The Curve:

October 10, 2008
HP-1195

G-7 Finance Ministers and Central Bank Governors Plan of Action

Washington-- The G-7 agrees today that the current situation calls for urgent and exceptional action. We commit to continue working together to stabilize financial markets and restore the flow of credit, to support global economic growth. We agree to:

1. Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.
2. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.
3. Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.
4. Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.
5. Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.

The actions should be taken in ways that protect taxpayers and avoid potentially damaging effects on other countries. We will use macroeconomic policy tools as necessary and appropriate. We strongly support the IMF's critical role in assisting countries affected by this turmoil. We will accelerate full implementation of the Financial Stability Forum recommendations and we are committed to the pressing need for reform of the financial system. We will strengthen further our cooperation and work with others to accomplish this plan.

-30-

Again, I think we're there.

Paulson Is On It Now

Paulson seems to get it now, but we've wasted a lot of time ( believe me, I realize I'm an armchair amateur writing a blog):

"Paulson Says Will Buy Bank Equity `Soon as We Can' (Update2)

By John Brinsley and Rebecca Christie

Oct. 10 (Bloomberg) -- U.S. Treasury Secretary Henry Paulson said the U.S. will buy equity ``as soon as we can'' in banks and other financial institutions to restore market stability and revive economic growth.

The Treasury is ``working to develop a standardized program that is open to a broad array of financial institutions,'' Paulson said at a press conference after a meeting in Washington of finance ministers and central bankers from Group of Seven countries.

The injection of equity would be aimed at sustaining banks and other financial institutions through the worst credit crisis in seven decades. Paulson declined to give a timetable or details about the purchases, and signaled that markets may be in for turmoil ahead.

``We're going to do it as soon as we can do it and do it properly and do it effectively and right,'' Paulson said. ``Trust me, we are not wasting time; people are working around the clock to deal with this.''

We've Arrived

We've arrived:

G-7 Pledges to Take `All Necessary Steps' to Stem Market Crisis

By Simon Kennedy and John Brinsley

Oct. 10 (Bloomberg) -- Finance ministers and central bankers from the Group of Seven nations said they're prepared to take ``all necessary steps'' to unfreeze credit markets and prevent financial companies from failing.

``We commit to continue working together to stabilize financial markets and restore the flow of credit, to support global economic growth,'' the policy makers said in a joint statement after talks in Washington.

They also pledged to support banks important to the financial system and ensure that companies are able to raise enough capital to reestablish confidence. There was no comment on exchange rates in the one-page statement.

The policy makers from the U.S., Japan, Germany, U.K., France, Canada and Italy convened at the end of a week in which $6 trillion was wiped off investors' wealth and on a day that the Dow Jones Industrial Average whipsawed by the most in history.

``This G-7 meeting is a defining event and they have to do something really radical,'' Harvard Professor Kenneth Rogoff said in an interview before the statement was released.

The G-7 is under pressure to roll out new policies to quell the panic in markets after its previous steps failed to do so."

Rogoff makes the essential point.

On Coordination, which finally happened this week:

"Global Coordination

In the past two weeks alone, global central banks executed emergency interest rate cuts and pumped more cash into markets, the Federal Reserve said it would buy U.S. commercial paper, European governments bailed out banks and the U.K. and U.S. said they would start taking equity stakes in financial companies.

Money markets remain gridlocked despite those efforts as banks shun lending to each other for fear they will lose the money or because they need it themselves. The resulting jump in borrowing costs is now strangling consumers and companies, prompting Merrill Lynch & Co. to predict the G-7 economy will be the weakest next year since 1982."

There's no going back now, and, again, we were always going here, for good or evil. Start thinking about the ramifications.

The Implicit Assumption I've Been Talking About

Vindication. Check this quote out:

“It is a must for the G-7 countries, especially the U.S., to make a firm commitment to public fund injections for recapitalization of banks in trouble, in order to see the stock market pull out of the doldrums,” Hideyuki Suzuki, an analyst at Morningstar Japan told Reuters. “If the G-7 nations failed to do so, its raison d’être will be called into question for sure.”

As I've been saying, this was the implicit assumption all along.

Were Going There, But Will It Work Now?

From the NY Times story "Panic Strangles Asia Stocks, Yen Jumps":

"No one is buying. Fundamentals don't matter any more and there's no explanation for such a plunge," said Yoshinori Nagano, chief strategist at Daiwa Asset Management in Tokyo, of the selloff in Japanese stocks."

That's not good news.

Here's more:

"The iTRAXX Asia ex-Japan high-yield index, a key measure of risk aversion for the region's "junk"-rated credit, soared about 90 basis points to a record 890/940 bps, a Singapore-based fund manager said. But traders warned of little activity in the credit markets, which tends to magnify price differences.

Extreme market volatility stoked talk that the major central banks would have to reduce interest rates again, just days after a concerted round of cuts led by the Federal Reserve and European Central Bank. There were also reports the U.S. Treasury was under intense pressure to inject funds directly into commercial banks.

"It highlights the enormity of the issue and the problem faced by the G7," said Adam Carr, a senior economist at broker ICAP. "Given the muted response in markets, certainly I think more rate cuts are to come, as ineffective as they are proving. Lets hope the G7 propose a good dose of fiscal medicine to the real economy as well."

Whether or not global policymakers have anything more planned, time was running thin.

The spread of 3-month London interbank offered rates over the 3-month U.S. Treasury bill yield widened to 426 bps, increasing more than 300 bps in the last month, with cash being hoarded and practically no lending between banks."

What's a good dose of fiscal medicine? We could sure use it.