Debt accumulation still a threat, reforms needed

The financial system has reached a significant stability over the past six months, but some of the root causes of the crisis remain. One of those is an accumulation of debt. The implications of the stocks of debt held by agents across the economy – the debt hangover – and the current opportunities available to pay them down, before describing two reforms that might curb the accumulation of debt in the future, have been the focus of a speech in Liverpool by Andrew Haldane – Executive Director for Financial Stability for the Bank of England.

To different degrees a debt hangover is affecting households, financial and non-financial companies and sovereign states around the world, but is perhaps greatest in the financial system. Mr. Haldane noted, in his speech, that to date the servicing costs of these debts have been cushioned by policymakers’ actions, but public sector support can only ever offer temporary relief – they are not a long-run cure.

Which options are open to restore normal conditions? First, banks should take advantage of the profits they have achieved this year to bolster their balance sheets. “There is a strong case for banks, in the UK and internationally, pocketing this windfall rather than distributing it to either staff or shareholders.” That is, the bank of England is saying ‘no’ to the megabonuses banks and financial companies seem ready to pay their high level managers, as if the past 18 months had been no use. The very position expresses by the US President, Barack Obama days ago. This would allow banks’ balance sheets to be repaired while supporting lending to the real economy. Mr. Haldane expressed worries, though, there has been little evidence of such prudential opportunism thus far.

Second option, he says there is a case for restructuring debt claims into equity to benefit both lenders and borrowers. A number of global banks have, in effect, already initiated such strategies and they could help improve balance sheets across all sectors.

Debt crises cannot be eliminated, but their frequency and scale might be moderated. In order to do that, reforms are necessary. He suggested two in particular: First, macro-prudential policies should be designed to curb the credit cycle, and lean against the collective tendency for banks to make significant distributions even when profits are low; second, a redesign of debt contracts, such that they become state contingent. “If contingent capital became more widespread, banks’ capital ratios would be automatically stabilised over the cycle, lowering the chances of future banking crises.” He also believes there is merit in considering how state-contingent debt might be adopted in other sectors.


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