Ringfencing The Financial System

The strains are back with a vengeance in the global financial system - banks everywhere, from Germany to the U.S., are fessing up to more losses, the Irish government stepped in to nationalize one of the country's largest banks, financial stocks have led share markets lower (though today, the market's animal spirits seemed to come back a bit before everyone got distracted by the plane that landed in the Hudson river). Yet the usual stress gauges were pretty well-behaved Thursday, even as Bank of America stocks hit the skids and were down 20% at some point: Libor/OIS - the difference between interbank lending rates and the Fed's expected rates - barely budged, three-month Libor ticked up a smidgen and is very likely to rise by more in the coming sessions - but the crucial difference between January 2009 and September/October 2008 is that the central banks, by cutting rates sharply and pumping cash into the economy with all their might, have built a firewall to stop the financial forest fire from spreading.

With global central banks the main takers of risk in financial markets, the banking system now has time to sort itself out without the rest of the credit markets going into deep freeze. And there's a lot of sorting out to do: the tab for investing in those fancy supposedly safe structured products keeps rising: estimates now put it at just over $2 trillion (of which banks globally have taken about half the losses so far). It's not just Citi that is going to need a "good" bank/"bad" bank solution - in which the toxic assets are separated out and handed over to the government, with some kind of profit-share agreement to make the low price banks will get for these assets tolerable. Already, some are wondering whether it really was just Merrill's dismal 4th quarter performance that made Bank of America go cap in hand to the Treasury. And JPMorgan's 4th quarter profit was largely due to its takeover of Wachovia. Deutsche Bank is looking at a $5 billion-plus loss for the fourth quarter and is trying to stave off the inevitable with some fancy deal with Deutsche Post.

What's clear is that we can't afford to just sit back and wait for the banks to get a grip on this mess of their own accord- just look at how long it took Citigroup to acknowledge what everyone has been saying since August 2007: in its current form, it cannot be managed properly. Supervisors as part of the government need to remember that they are the guardians of the public's tax monies that are being pumped into the financial system. They need to lay down the law - as apparently the FDIC did, insisting that Citi address its problems (that doesn't speak well of the Fed as super-regulator but then, the Paulson plan may be obsolete now) - or else we'll still be dealing with a feeble banking system when current President-elect Obama finishes his second term.