ECONOMIC CRISIS RX - VIEW FROM THE CITY

C O N F I D E N T I A L SECTION 01 OF 02 LONDON 002760

SIPDIS

DEPT FOR PDAS NELSON, MSAKAUE
TREASURY FOR MURDEN, CARNES,

E.O. 12958: DECL: 10/30/2015
TAGS: ECON, EINV, UK
SUBJECT: ECONOMIC CRISIS RX - VIEW FROM THE CITY

REF: A. LONDON 2738
B. LONDON 2710
C. LONDON 2683
D. LONDON 2603

Classified By: Economic Minister Counselor Mark Tokola for reasons 1.4
b and d

1. (C) Summary: Political leaders must tackle not only the
liquidity and solvency of financial institutions, but also
must now confront significant currency volatility and a
deepening cross-border contagion. While acknowledging there
are no quick fixes, officials from two leading financial
institutions - Stephen King, Chief Economist, HSBC and
William Chalmers, Managing Director, Investment Banking
Division, Morgan Stanley - identified several possible
policy prescriptions in October 28th meetings with emboffs:
injection of cash into economic systems, full disclosure of
toxic assets, and the creation of a framework for a
supra-national regulatory agent. They also explained why,
in their view, government recapitalization efforts have
failed to stabilize markets. End Summary.

Currency Stability

2. (C) In today's turbulent times, cash is paramount and
governments must ensure that as much money as needed is
available, said King. Political leaders need to indicate
that they are prepared to inject cash into the economy
without limit and regardless of inflationary concerns to
assuage fears of investors and prevent cash hoarding. He
cautioned, however, that no one country should proceed
unilaterally. Coordination among the G7 would limit the
danger of cross-currency contagion. He also noted that
central banks, ability to increase the money supply through
open market operations has been only nominally successful
during the crisis, given the paralysis of inter-bank
borrowing. The European Central Bank (ECB) is also more
hamstrung than the Federal Reserve in terms of increasing
liquidity through cash injections, since the ECB is built to
deal with inflation and has little authority independent of
member state governments in matters of liquidity, King
stated. In his view, governments need to bypass the banking
system and inject liquidity directly into the economy via
increased government project spending.

3. (C) The spillover of currency volatility on trade and the
global de-leveraging process is also of significant
concern, observed Chalmers. The valuation of toxic assets is
more difficult when the currency in which those assets are
denominated is unstable. He also argued that political
leaders need to make both a verbal and concrete pledge to
ensure currency stability. Without such an assurance, the
contagion effect has the potential to cripple European
banks.

4. (C) Governments also have been unable to control the speed
of de-leveraging - the selling of commodities and assets to
reduce risk and raise capital, said Chalmers. The market
panic of recent weeks is evidence that statements by
political leaders have proven to be ineffective in
controlling the pace of de-leveraging.
Political leaders need to issue a coherent, strong and
combined message that measures in place will work and seek
patience from investors and savers, he stated.

Toxic Assets - Fuller Disclosure

5. (C) Many banks have not come clean about the extent of
their toxic assets on their balance sheets, said King.
Political leaders and regulators should underscore the need
for greater transparency and establish mechanisms to force
fuller disclosure, if not voluntarily done by the banks. He
argued that there is a need for an independent authority to
investigate each bank as well as a cross-border evaluation
process.

6. (C) Fuller disclosure about assets is necessary but there
is a potential trade off between greater transparency
and liquidity, said Chalmers. The real value of assets, if
disclosed, could make those assets illiquid. He also argued
that non-regulated instruments - such as hedge funds - also
need to be subject to greater transparency requirements.

Regulatory Framework

7. (C) The industry expects more rigorous regulation,
remarked King. But he warned that regulators need to really

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understand market instruments before developing and imposing
new regulations. Some of these regulators need to
have been market insiders and not just government
technocrats. "Poachers need to become the ranchers," if
governments are to stay ahead of market mechanisms.

8. (C) Going a step further, King said that the architecture
of the global financial system needs to change
so that there is a single global capital market with
sovereign nations managing their individual economies.
This will require a new global framework, a Bretton Woods
Two, he said. He warned however, that if this is not done
skillfully, there is a danger that nations will revert to
capital market protectionism. This would have the same
adverse impact on world economic growth as the Smoot-Hawley
Tariff Act of 1930, but the mechanism would be through the
capital markets rather than trade.

9. (C) Chalmers argued that there is a need for a
supra-national structure in place of the independent,
loosely coordinated responses of sovereign states. He stated
that this could through greater formalized process
of cooperation among national regulators - a "college of
regulator" such as PM Brown has proposed - or through
the ceding of some sovereign authority to a supra-national
organization.

Investors Remain Skeptical

10. (C) The gyrations of the world's financial markets
demonstrate that recent policy decisions have not been
correct, argued King. Interest rate cuts have had negligible
effect since the real root of the crisis is
solvency, not liquidity, he argued. Governments,
recapitalization plans also have had a minimal effect since
the markets are skeptical about whether the amounts will
prove to be sufficient. What is the right amount of money
- USD 700 billion, GBP 500 billion? queried King. The
capital injections were needed to prevent institutions from
going bust, but he warned that there are many Zombie
Banks,, with crippling levels of loans to securitization,
that still haven't come to light. How much could governments
borrow to resuscitate these banks? he asked.
Without an open-ended funding commitment for
recapitalization, the markets will remain skeptical that
there will be enough funding for the distressed banks.

11. (C) The lack of clarity of how and when governments will
divest themselves from the troubled banks also is
sending a negative signal to the market, said Chalmers.
Potential investors in these banks want a timetable - such
a timetable will also show confidence in the markets and that
recovery is attainable, he argued.


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