G7 central bank governors and finance ministers -- from the United States, United Kingdom, Canada, Italy, France, Germany and Japan -- gathered in Tokyo on February 9. While promising to strengthen financial system stability, they eschewed calls for common fiscal and/or monetary actions to counter the impact of the sub-prime mortgage and related credit crisis:
Bank of Canada Governor Mark Carney pointed to interest rate cuts in the near future, while comments from European Central Bank (ECB) President Jean-Claude Trichet lent credence to the belief that the ECB may be forced to change course and lower rates.
Meanwhile, Germany and Japan indicated they have no intention of following the US example, with a 'fiscal stimulus' package. Financial crisis. The Financial Stability Forum (FSF) working group's interim report, commissioned by G7 ministers last October, represented the highlight of the meeting. The FSF report stressed the depth of the current financial crisis:
More writedowns. Disclosure by banks and other financial institutions impacted by the sub-prime crisis of their losses and asset valuations is still far from complete. German Finance Minister Peer Steinbrueck suggested that full disclosure could necessitate bank writedowns of up to 400 billion dollars -- nearly four times the amount disclosed by leading US and European banks to date. Capital deficiency. Complete disclosure increases the likelihood of severe aggregate capital deficiency among banks and other financial institutions. Bank of Italy Governor Mario Draghi suggested that funds for recapitalising these institutions might not be readily forthcoming from stock markets already "battered" by sub-prime fallout, or from sovereign wealth funds, on the scale required. This could increase the need for capital injections using public funds.
Upcoming audits. Over the next two weeks, leading banks will publish their first audited accounts since the sub-prime crisis erupted. Draghi, the FSF working party's chair, suggested that timing may be "crucial". Auditors have become more vigilant in the wake of the crisis, which could lead to higher levels of writedowns than preliminary bank results suggested.
Crisis sources. The FSF report identified specific weaknesses that helped precipitate the current crisis. These included:
poor underwriting and some "fraudulent practices" in the US sub-prime mortgage sector;
shortcomings in financial firms' risk-management practices;
weak investor due diligence;
insufficient incentives for parties to provide adequate information on quality and performance of underlying assets;
compensation schemes in financial institutions that encouraged disproportionate risk-taking;
public disclosure requirements that did not clarify risks associated with off-balance-sheet exposures; and
poor performance by credit rating agencies in evaluating risks in sub-prime-backed securities. Crisis amplification. Unforeseen linkages have amplified the crisis. While the FSF admitted that "not every market failure has an appealing or effective regulatory solution", understanding and breaking these linkages is important:
Supervisors and regulators need to ensure that risk management and control frameworks keep pace with innovations and dynamic change in financial markets and business models.
Where market discipline fails, the scope of regulatory coverage should be expanded. Progress made. The FSF acknowledged some improvements since the onset of market turmoil:
De-leveraging in the structured investment vehicle (SIV) sector has reduced potential for further downward pressure on markets.
Coordinated central bank liquidity operations have eased strains in money and interbank markets.
Some leading financial institutions have disclosed losses and taken steps to raise new capital.
Generally, capital buffers at large institutions remain "well above regulatory minima".
Upcoming risks. Even given progress, there are growing concerns about whether asset price declines, and anticipated credit impairment, will impact financial institutions' capital and lending capacity:
The potential exists that risk-shedding could tighten constraints on a widening set of borrowers, and thereby slow economic growth.
Meanwhile, the risk remains "that further shocks may lead to a recurrence of the acute liquidity pressures experienced last year", the FSF report suggested.