How to solve this crisis

I am more than a little tired of seeing statements like this from the Bank of England:

"In response to continued strains in short-term funding markets, central banks today are announcing further coordinated actions to expand significantly the capacity to provide U.S. dollar liquidity. Central banks will continue to work together closely and are prepared to take appropriate steps as needed to address funding pressures."

This announcement was published today and at least nine other banks produced something similar, shouting to the world their involvement in yet another short term emergency liquidity operation.

The Fed, the BoE and the ECB have been at this lark for well over a year. Each time a bank wobbles, the world's central banks flood the market with short term cash. Somehow, it never seems to calm things down. So what is going wrong?

Problem No. 1 - Inconsistency - The world understands that the rules of the game in the world of finance have changed. However, no one can figure out the new rules. The Fed, along with the other central banks and financial supervisors are destabilising markets.

Their attempts to rescue the financial system are far too ad hoc; Lehman is wiped out; but Bear Stearns is bailed out. AIG gets a loan, but the treasury demands an equity stake and a crippling interest rate. Freddie and Fannie first get some credit guarantees, and then nationalized. An appallingly conceived bail out plan is announced and then renegotiated by politicians. There is no pattern, no predictability and huge uncertainty.

The FSA isn't much better. It has pursued a slightly less publicity driven strategy of quietly pressurizing weak banks to take over insolvent ones. It hasn't done much to calm the interbank market and it has left problem banks like the B&B dangling in the wind for far too long. They should have moved against the B&B once it was clear that the rights issue had failed. Instead, it waited until there were incontrovertible signs of a run on retail deposits.

Problem No. 2 - Panic dressed up as action - There is however one pattern that has emerged. Central bank policies are "event" driven. There is very little strategic thinking or long term planning. Here are two examples.

February this year, the Fed woke up to find stock markets falling. It feared a global financial meltdown and dramatically cuts interest rates. Later, we found out that Société Générale was unwinding an unauthorized derivative position, which had been putting temporary downward pressure on equity prices. The rate cuts were largely unnecessary at the time and ultimately limited the Fed's policy options going forward. It was a costly mistake.

Here is another example, the BoE and the FSA woke up one morning and foundthat there was a bank run on Northern Rock. They then discovered that UK deposit insurance was totally inadequate. In a fit of panic, the Treasury gave a blanket guarantee on just NRK deposits, leaving the status of other banks ambiguous. Eventually, this ambiguity weakened other banks, notably the Bradford and Bingley. Even after that second failure, UK deposit insurance policy is totally unclear.

Problem no.3 Liquidity is not enough, the banks are broken - There is no easy way of saying this, but many of our banks are insolvent. Pumping in huge amounts of liquidity doesn't change that fact, it merely hides the problem. What we need is a comprehensive solution for rescuing bankrupt banks and transforming them into solvent ones.

This requires public intervention. However, this intervention must follow some simple principles. The British people will accept a bank bailout plan so long as it is fair, transparent and minimizes the total cost to the taxpayer.

The first principle simply requires that as much of the losses as feasible are borne by current participants in the industry. Shareholders must be wiped out and existing management thoroughly purged.

The second principle requires the government to announce a comprehensive plan as soon as possible. Moreover, it needs to be one that ordinary people understand. This means clearly defined thresholds for nationalization. Decisions need to be quick and resolute. Above, clarity and not discretion is needed.

Finally, the last principle needs to ensure that the taxpayer receives the full benefit of the bailout. This means that all rescue plans go through a nationalization process and a subsequent sale. There can not be any sneaky deals with insiders where assets of one distressed bank are handed over on the cheap to another marginally more healthy one.

The JP Morgan and Fed stitch up of Bear Stearns might seem like a good idea at the time, but it only served to undermine confidence in the Fed's ability to solve this problem fairly and transparently. Similarly, the futile attempts to hand over NRK to private equity firms just served to drain public confidence in the Treasury, the BoE and the FSA. So, no more of these dubious private market solutions. The new rule should be nationalise and then, when the moment is right, privatize.

We are in a mess and we need a plan

The crisis is getting worse, and I get the feeling that yet another announcement of more liquidity just isn't going to do the trick. We are running out of time; the financial system could totally collapse in much the same way as the East Asian systems collapsed back in 1997-8.

At this late stage, we don't need any more half baked, "we will make it up as we go along" strategies. Instead, we need a comprehensive, principles-based resolution strategy that makes our bankrupted banks solvent again.