In its annual report, released June 29, the Bank for International Settlements (BIS) warned worldwide rescue efforts for the financial industry might be inadequate.
Central banks and governments need to start planning their exit strategies now, the BIS said. "The increased government spending that may have been necessary to limit the decline in employment and production in the short term will, if overdone, do more harm than good," it stated, while stressing the need for orderly withdrawals from state involvement in the financial system. At present, central banks are acting as the "intermediary of last resort", and this must end if the financial system is to recover, the BIS added.
Banks, meanwhile, were criticised for being too slow to recognise losses from holdings of toxic assets. Slow resolution meant "market participants have been unsure about the size and distribution of losses as well as about the timing of loss recognition. This uncertainty has served only to prolong doubts and frustrate government efforts to restore confidence in the financial system," the BIS said.
The continuing problems of the financial system are also reducing the effectiveness of stimulus programmes on the wider economy, it added. Stimulus programmes are also likely to be delayed due to legislative impediments, and could end up either exhausting the capacity of governments to raise more credit, or driving up interest rates and retarding recovery. Rate cuts and balance sheet expansion also raise the risk of high inflation, it said.
The BIS called on banks to rethink their funding models to take account of regulatory restrictions on securitisation and the likely rise in the cost of wholesale funding. "In the end, institutions are likely to be smaller, with less leverage, and their owners will almost certainly have to learn to live with lower rates of return," it said.
Supervisors and policymakers in the US and Europe are wrestling with how to regulate systemically important institutions – the so-called 'too big to fail' firms. But BIS suggested modern international banks were too large for any coherent risk policy to work. "Enterprise-wide risk management would seem to be an impossibility in such cases," it wrote.
The BIS also warned governments might reduce or halt their efforts as soon as they saw signs of recovery, creating the risk of stopping too soon. But, it added, interventions still need to be ended as soon as practical, as they are creating concentrations of risk and moral hazard that will make the system more unstable. National supervisors might also be tempted to impose more restrictions on cross-border capital flows, potentially creating a safer but less efficient financial system, and a more stable but less dynamic global economy.
See also: Bank of England calls for "credible threat of closure"
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