The Bald and The Beardful

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Are there some basic rules of conduct?

The fact that there is no universally applicable answer doesn’t necessarily imply that there is not a certain set of rules, which must be ap-plied in order to solve a crisis. In their seminal work on the Panic of 1907, US economists Robert Brunner and Sean Carr stressed out over the failure of collective action which could worsen and deepen a crisis.

In a nutshell, the Panic of 1907 was a financial crisis in the US and especially in New York City, which was characterized by numerous runs on banks and trust companies. It started with a failed attempt of some investors to corner the copper market, leading to a first run on the Knickerbocker Trust company - the very bank that was backing the rogue investors and loaning them money for their scheme. The crisis then spread to several other banks. Back in 1907, the Fed didn’t exist, so there was no clear lender of last resort or an obvious way to stem the crisis.

In that particular case, it took the leadership of the legendary banker John Pierpont Morgan. He gathered a circle of influential New York bankers and forced them to form an association aimed at supporting the distressed financial institutions. Moreover, once this group was in place, there was a very strong commitment to draw a line in the sand: "the trouble stops here." And the crisis ultimately ceased at the Trust Company of America, which was fully backed by this informal group.

What are the lessons for today?

The current crisis started to unfold more than a year ago. In a first step both the Federal Reserve and the European Central Banks provided ample amounts of liquidity to mitigate the most immediate liquidity problem. Moreover, the Fed slashed its fed fund rates quite significantly, bringing them down by 325 basis points from 5.25% in Sep-tember 2007 to 2% by the end of April 2008. Finally, the Fed greatly expanded the space of collaterals, which financial institutions can use to draw upon Fed facilities. Last September, US treasuries were amounting to 85% of all assets of the Fed; a year later, we estimate they only account for roughly 43%. This past Sunday's announcement that, under specific conditions even equities could be used as collateral now, will further dilute the Fed’s balance sheet.

The level of intervention from the authorities to solve or at least mitigate the current crisis is therefore beyond any critique (of course, unless you think that nothing should be done at all). However, the les-son from the past shows that we must see rule-based action, clear communication, a credible leading coalition and a collaboration of private and public forces in an internationally coordinated fashion.

Consistency: Some distressed financial institutions were rescued (Bear Stearns, the housing GSEs and AIG); others were not (Leh-man). Either way, there were dismal consequences for the equity holders, but bond holders were treated differently. Of course, there were good reasons to act in a case by case. Nevertheless, an explicit rule covering which institutions are deemed too big to fail and which ones are not could certainly diminish the nervousness of the market participants. As in 1907, there must be some "line in the sand" somewhere, which needs to be clearly communicated.

Strong coordination and coalition between the private and the public sector: The interplay between the US government, the Fed and the major banks must work in a clear and transparent manner. Bank of America and Barclays pulled out of a possible Lehman deal on Sunday and the private sector was not able to find a solution for AIG. At the same time, a consortium of major banks (including Bank of America and Barclays) were building up a fund of USD 70 billion to help distressed financial institutions. Therefore, there is a lot of goodwill from all sides here, but in our view, the communication of it is not loud and clear enough to reassure the markets.

International coordination: The crisis originates in the US, which is likely seen both abroad and by the international organizations that would usually tackle this sort of crisis elsewhere (especially the International Monetary Fund or the Bank of International Settle-ments) as being "big" enough to solve it on its own. But there is also an international dimension to it. Non-US financial institutions are involved. Moreover, as we stressed in our Research Focus, "Cur-rencies: a delicate imbalance" at the beginning of this year, the crisis has much deeper roots than in just the US financial system and other influences are currently taking place, like the unwinding of carry trades.

Financial crises seldom die of old age but it takes leadership, will and loud and clear communication as well as some costs and losses to stop them, or else they will be destined to run their course.

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