The ending of the crisis in the financial sector is a prerequisite to any sustainable economic recovery. Fortunately, progress has been made in recent months, driven by government measures.

After the collapse of Lehman Brothers on September 15, 2008, the financial sector, which had already been under strain for over a year, saw its situation dramatically deteriorate. This collapse in fact cast doubt on the assumption that major financial institutionsare “too big to fail”. In other words, the idea that governments would simply come to their rescue to prevent a chain of bankruptcies. The emergence of this potentially devastating banking risk caused a widespread crisis of confidence and the paralysis of the financial markets and systems.

Restoring bank liquidity

With the freezing of the interbank markets, which under normal circumstances are used by banks for the short-term borrowing or lending of cash that they need or have a surplus of, the central banks reduced their key rates (from 4.25% in early October 2008 to 1% in early May for the ECB) and extended their measures for injecting liquidity into their banking systems, particularly the ECB.

Restoring the capital adequacy of banks to allow them to lend
Against a backdrop of high risk aversion, restricting access to private capital, governments increased the capital adequacy of banks through several waves of recapitalisations, and introduced systems for guaranteeing new medium-term debt issues to facilitate their refinancing. At the start of July, the ECB also launched a covered bond purchase programme totalling EUR 60 billion, re-establishing a major source of refinancing for European banks. In several countries (including the US, the UK, Benelux and Switzerland), the authorities either guaranteed, in exchange for compensation, portfolios of toxic assets on the balance sheets of banks hit particularly hard by the crisis, to limit the losses incurred, or created defeasance structures (bad banks) enabling banks to separate themselves from discounted toxic assets. These measures have made it easier for the banks concerned to return to normal operation and have strengthened their lending capacity.

Stimulating the financial markets
Finally, several central banks directly supported the debt security markets, which were strongly disrupted by the rise in investors’ risk aversion, by directly buying securities issued on these markets. The Federal Reserve was particularly active in this respect. The American economy is in fact mainly financed by the markets, unlike the euro zone where bank financing dominates.

Tangible results but no return to normal as yet
Besides preventing a major systemic crisis at the end of 2008 and a far more severe economic recession than the one we are already facing, although this has already reached historic proportions, these proactive policies have produced significant results, although the extent of the progress made varies depending on the category of financial asset.
On the interbank markets, the interest rates, which soared in autumn 2008 quickly fell, easing short term refinancing conditions for banks and consequently maintaining the credit supply. The affect of key interest rate cuts is therefore being felt more and more directly by private agents. The uncertainties regarding the quality of bank assets and, accordingly, the banks’ possible need for recapitalisation, have reduced but remain not inconsiderable as they also depend on how long the crisis lasts.
Two positive factors have recently been in play: the encouraging results of the stress tests conducted by the 19 largest American banks and the increasing number of economic indicators suggesting that the recession is entering a much more moderate phase than in late 2008/early 2009, as economic activity most likely bottomed out in Q2 09.
Bank lending conditions (interest rate margin, collateral and deposits requested) have continued to toughen in early 2009 due to the considerable rise in the cost of risk caused by the global economic crisis. The rate of this rise has slowed down greatly, however, compared to the end of 2008, both in the euro zone and the US.
As the prospect of a global systemic crisis has become much less likely and the likelihood of a long period of deflation and very low growth now appears to be far less of a threat, risk aversion on the financial markets has significantly reduced. Correspondingly, since January there has been a rebound in bond issues by nonfinancial companies, indicating the return of investors to the market, given that the issuers are high quality and the yields are attractive.
The equity and foreign exchange markets also seem to be on the right track: since March, the equity markets made good the losses reported in the first two months of the year, while emerging currencies, which are also benefiting from the increase in the IMF’s resources decided on at the G20 summit in early April, are tending to appreciate after plummeting at end-2008/early-2009.