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Financial repairs must continue: central banks

Globe and Mail Update

Ottawa — Governments and central banks must not let up in their efforts to revive the global banking system, even if public opinion turns against them, says the institution representing major central banks.

“It is essential that authorities persevere in repairing the financial system until the job is done, because as long as financial institutions are hesitant to finance economic activity, the prospects for growth are at risk,” Jaime Caruana, general manager of the Bank for International Settlements, told reporters on Monday after the bank's annual general meeting in Basel, Switzerland.

A solid and lasting fix of the system means forcing the banking system to: take losses; dispose of non-performing assets; eliminate excess capacity and rebuild the capital base.

While some authorities and financial institutions around the world have taken numerous steps to nurse banks back to health, the BIS sees only “limited progress.”

Instead of implementing policies designed to clean up banks' balance sheets, some rescue plans have pushed banks to maintain their lending practices of the past, or even increase domestic credit where it's not warranted, the BIS pointed out.

“Progress on problem assets has been slowed by the complexity of the securities affected, legal constraints and, above all, the limited political will to commit public funds to the clean-up effort,” the institution's annual report says.

“The lack of progress threatens to prolong the crisis and delay the recovery because a dysfunctional financial system reduces the ability of monetary and fiscal actions to stimulate the economy.”

That's because without a solid banking system underpinning financial markets, stimulus measures won't be able to gain traction, and may only lead to a temporary pickup in growth, the report says.

A fleeting recovery could well make matters worse, the BIS warns, since further government support for banks is absolutely necessary, but will become unpopular if the public sees a recovery in hand. And authorities may get distracted with sustaining credit, asset prices and demand rather than focusing on fixing bank balance sheets, the report said.

The BIS analyzed the causes of the financial and economic crisis, quantified the rescue attempts and assessed the chances of success going forward. It warned that despite the unprecedented measures in the form of fiscal stimulus, interest rate cuts, bank bailouts and quantitative easing, there is an “open question” whether the policies will be able to stabilize the global economy.

And as governments bulk up their deficits to spend their way out of the crisis, they need to be careful that their lack of restraint doesn't come back to bite them, the central bankers said. If governments don't communicate a credible exit strategy, they will find it harder to place debt, and could face rising funding costs – leading to spending cuts or significantly higher taxes.

“Getting public finances in order will therefore be the main task of policy makers for years to come,” the annual report said.

In the future, developed countries that previously relied on leverage to propel growth need to change their borrowing patterns, Mr. Caruana added. And developing countries that were dependent on exports need to shift production so that it is partly based on domestic demand.

“Not everyone can export their way out of the crisis,” said Stephen Cecchetti, chief economist for the BIS.

The crisis has shown that central bankers will need to pay far more attention to credit flows and asset prices, the BIS said, although it stopped short of recommending that central banks actually target asset prices with their monetary policies. Rather, central banks should analyze credit and asset prices, and sound warnings if bubbles are forming.

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