Faced with growing fears of systemic catastrophe, authorities in the U.S. and Europe are ramping up their efforts to salvage the financial system. And only time will tell if they have done enough.

The global financial crisis reached a fever pitch in mid-October as banks around the world effectively stopped lending to one another, and rates for interbank borrowing soared in response. Amid increasingly dire predictions of both financial and economic calamity, governments in the U.S. and Europe have now admitted that a comprehensive solution is necessary.

Abandoning the one-off efforts targeted at troubled institutions, governments are now scrambling to prevent a systemic meltdown by introducing a swath of initiatives aimed at boosting market liquidity, stabilizing troubled banks and restoring confidence to the overall financial system.

While governments’ efforts are slightly different, the mechanics are similar — governments are seeking to shore up the system by injecting capital into needy banks and enhancing both retail and institutional confidence with beefed-up guarantees on deposits and new guarantees on interbank lending.

It’s difficult to put a price-tag on all of the schemes that have been announced in recent days, but it is in the ballpark of US$5 trillion to US$6 trillion. (About half of that is attributable to U.S. government action, and half to Europe.)

The British government led the way with a US$850-billion plan to shore up its financial services firms. That was quickly followed by various European governments pledging US$1.5 trillion to similar plans in their respective countries.

The U.S. is following suit; it is devoting US$250 billion of its existing US$700-billion plan (designed to buy troubled mortgage assets) to the task of injecting capital into banks instead. Couple that strategy with the amount the U.S. government is spending to rescue failed mortgage underwriting giants Fannie Mae and Freddie Mac, plus the cost of its program to backstop money market funds and various efforts to inject liquidity into the global financial services system through the mechanisms of the U.S. Federal Reserve Board (including a new commercial paper funding facility) — and, economists at TD Bank Financial Group estimate in a recent report, the total amount of various U.S. government actions is about US$3 trillion.

In addition to massive bailout efforts in countries in which the trouble has been most acute, various governments have stepped up with initiatives of their own. Australia, Hong Kong, Singapore, Malaysia and Indonesia have all announced plans to enhance deposit guarantees, along with a handful of other local measures.

The issue for countries that don’t have banks in serious trouble is that their relatively healthy institutions risk being put at a competitive disadvantage by the various confidence-inspiring measures that are being introduced elsewhere — particularly at a time of heightened market fear.

This is essentially the situation that the Canadian financial services industry finds itself in. Our domestic banks are in relatively good shape. Indeed, the World Economic Forum recently rated Canada’s banks as the most stable in the world. (See page 44.) And, in a recent research report, Standard & Poor’s Corp. says that it views Canadian banks as having “substantially more robust balance sheets and capital positions and lower risk profiles” than their U.S. and European counterparts.

Yet, the sweeping actions by the governments of other developed countries to restore confidence in their financial services institutions risks putting Canadian firms at a competitive disadvantage. To avoid that possibility, following the G-7 meeting in Washington, D.C., in mid-October (at which participants agreed on the general principles they would follow in resolving the financial crisis), Canada’s Finance Department has declared that it would take whatever actions it deems necessary to keep Canadian banks on a relatively even playing field with the rest of the world.

That pledge has led to whispers that Canada could follow the lead of other governments and expand deposit guarantees or interbank lending guarantees. Yet, as Investment Executive went to press, nothing that dramatic had been announced. Instead, the Bank of Canada has pledged to boost financial services system liquidity by increasing the size of the BofC’s existing short-term liquidity facility and introducing a new facility that would be open to market players other than the primary dealers that typically participate in these auctions.

The BofC has indicated that institutions that “can demonstrate significant activity” in the money markets and which are subject to either federal or provincial regulation would be eligible to participate in the new facility — a move that may open the BofC’s spigots to fund managers, among others. Further details of this new liquidity effort were expected in the days leading up to the first auction, scheduled for Oct. 27 (after Investment Executive went to press).

@page_break@In addition to these efforts, the Canadian government has announced that it will buy up to $25 billion of insured mortgage-backed securities through the Canada Mortgage and Housing Corp. The TD report says that this initiative should be a win/win for banks and the government, in that it provides liquidity to the banks now and in the future the government will make a profit on the securities it buys.

Along with the federal government’s efforts to expand liquidity and balance sheet flexibility, Canada’s Accounting Standards Board has also announced that it will give firms increased freedom to reclassify financial assets so that they aren’t subject to fair-value accounting. (See page 12.) The AcSB explains that this move, which may help firms avoid taking massive mark-to-market writedowns when markets aren’t functioning properly, was made to keep Canadian rules in step with U.S. and international accounting standards.

Notwithstanding these latest steps, the Canadian government’s efforts remain far less extensive than those introduced in much of the rest of the world.

“The more limited policy response in Canada,” says the TD report, “is a testimony to the fact that the Canadian financial system has remained on a sound footing throughout the credit crunch.”

While Canadian banks have suffered losses as a result of their U.S. exposure, the TD report suggests: “The greater challenge for Canadian financial [services] institutions has come from the higher costs of raising capital in global markets and the resulting lower profit margins on many products.”

If the massive efforts of various governments to bail out the financial services system do the trick, one of the first signals will be a reduction in bank funding costs. But there’s no guarantee that these unprecedented efforts will work. Many analysts seem to believe that the rescue will succeed, but, they caution, markets will not return to normal overnight.

According to a report from New York-based brokerage firm Morgan Stanley Inc., countries that have dealt with previous financial crises have ultimately realized the importance of restoring both market confidence and bolstering bank capital. Past rescues have had to target both issues, the report says.

Simply boosting banks’ capital positions without first restoring market confidence probably won’t work, the Morgan Stanley report cautions: “Banks depend on deposits, commercial paper and debt to finance 95% of their tangible assets. Lacking trust in those liabilities, a further run on the banks is a real risk.”

Analysts suggest that with the latest sweeping plans, governments have finally sent the message that they will rescue financial markets by whatever means necessary, which should bolster confidence. However, it will take some time for faith to be restored, and even longer before households and businesses see easier access to credit.

“The steps taken should end the systemic risk in the financial system,” observes a report from New York-based research firm CreditSights Inc. “But it is less clear that they will ease lending conditions across the corporate and consumer landscape.”

In the short term, credit markets will need time to assimilate the impact of the bailout packages. “The numerous programs announced both in the U.S. and globally have come so fast and furious that confusion about the full slate of efforts still exists among market participants,” notes the CreditSights report. As a result, credit remains constrained, it adds: “So far, the government is lending to banks, but the banks are lending to no one.”

The Morgan Stanley report concludes that the combination of confidence-inspiring and capital-raising measures will “greatly help” reduce the risk of a deep and prolonged recession. But, even after the frozen funding and securitization markets thaw, the report cautions: “It will take time for banks to ease lending standards and for borrowers to gain access to credit.”

Moreover, there are other factors that continue to undermine market confidence. The ongoing fallout from the Lehman Brothers Holdings Inc. collapse, including the unwinding of its derivatives positions, is a big threat hanging over financial services firms.

Indeed, the decision to let Lehman Brothers fail was a critical mistake that touched off a complete breakdown in trust among the banks, argues a research report by Brussels-based Fortis Bank SA: “The consequence of the Lehman failure killed confidence between banks, as it created uncertainty over which bank was contaminated with Lehman paper. In addition, future risk ballooned as banks wondered about the balance sheets of other counterparties struggling in markets.”

There’s yet more uncertainty hanging over the markets, not least because of the suspect fortunes of the hedge fund industry; returns have been dismal and redemptions are expected to spike. This, in turn, may nurture more fear and intensify selling pressure as funds liquidate to meet redemption obligations.

Other shocks may materialize, too. The TD report notes that the U.S. housing market may still face large price declines: “The global economy is headed for a recession, and while this is increasingly being priced into financial markets, there is still a risk that the full extent of the weakness is not anticipated. Financial problems overseas also pose a risk of filtering back to the North American financial services sector.”

Governments may finally have a grip on this crisis, but that doesn’t mean they have any easy answers for it. IE