The credit crunch has already elicited extraordinary efforts from policy-makers and financial services firms to keep the global financial system afloat, but it appears there’s plenty more to be done.

Despite all the efforts to shore up the financial system by pumping in massive amounts of liquidity, nationalizing some of the most troubled firms and backstopping banks with measures such as interbank lending guarantees, government purchases of troubled assets and, in many countries, capital infusions, the world’s financial system is still troubled. Credit remains constrained; banks remain under pressure. The restructuring of the financial services industry is clearly far from over.

This past fall, in the two tumultuous weeks after investment bank Lehman Brothers Holdings Inc. was allowed to fail, the financial services industry underwent a lightning-fast makeover. Several large, failing firms in the U.S. and Europe were propped up by their governments. The large, stand-alone Lehman Brothers disappeared overnight, and the biggest firms on Wall Street scrambled to find a buyer (Merrill Lynch & Co. Inc.); raise capital from outside investors (Morgan Stanley Capital Inc.); or announced plans to convert into bank holding companies (Morgan Stanley and Goldman Sachs Group Inc.), which would allow them to grow their deposits and support their businesses as other sources of funding disappeared.

That storm eventually passed — thanks, in part, to the U.S. Congress agreeing to create the Troubled Assets Relief Program. One purpose of this US$700-billion bailout is to buy troubled mortgage assets from banks, freeing up the banks to supply credit to households and businesses. But the conditions that created the initial tempest have yet to disappear. Indeed, some of the same issues are rearing their heads once again.

Bank nationalization has resurfaced in Europe as, in mid-January, the government of Ireland announced that it will take over Anglo Irish Bank Corp. PLC, which the government deems is systemically important to the Irish financial services industry. Ireland’s government indicates that the funding position of the bank has weakened to unacceptable levels and it has incurred “serious reputational damage,” leading the government to conclude that public ownership is necessary to ensure the bank’s continued viability.

The U.S. government is likewise back to bailing out troubled firms. It has asked for the remaining US$350 billion of what was originally contemplated under the bank bailout package. (Initially, Congress had authorized only half of the TARP funds for immediate deployment.

The first time around, the U.S. Treasury was supposed to use the TARP funds to purchase troubled mortgage assets, but it ended up making capital investments in banks instead. Now, it remains to be seen what the new administration of President Barack Obama does with the other half of the TARP funds.

One possibility is further capital injections, or the new administration could return to the bailout plan’s initial strategy of taking toxic assets off banks’ balance sheets. In a mid-January speech to the London School of Economics, Ben Bernanke, chairman of the U.S. Federal Reserve Board, suggested that the U.S. Treasury could simply buy up assets, provide portfolio guarantees or set up so-called “bad banks” to buy these assets, as has been done in several other banking system bailouts in history.

The problem, Bernanke said in his speech, is that the presence of these assets on banks’ balance sheets is inhibiting lending and credit growth. On top of that, he pointed out, with the worsening of the economy’s growth prospects, the continued credit losses and asset markdowns that banks’ balance sheets may maintain under stress will increase the pressure on banks to raise still more capital.

Indeed, that pressure has become evident once again in some large U.S. financial services institutions. Bank of America Corp. — one of the heroes of the crisis this past fall for agreeing to take over Merrill Lynch in a surprise, seemingly overnight deal — has since discovered that Merrill’s troubles were deeper than BofA thought when it agreed to the shotgun marriage.

In its latest quarter, BofA reported a US$2.4-billion net loss, not including an expected US$15.3-billion quarterly net loss at Merrill. As a result, BofA has turned to the U.S. government for a US$20-billion capital infusion and an arrangement to guarantee a US$118-billion pool of assets against extraordinary losses.

Another survivor of the original storm, Citigroup Inc. , has since taken a battering, too. In its latest quarter, it reported a US$8.3-billion loss. As a result, it has decided to break itself into two businesses, separating the core banking operations (to be known as Citicorp) from businesses it deems non-core, including its brokerage, asset-management and consumer finance divisions (to be known as Citi Holdings).

@page_break@The decision to split up Citigroup follows hard on the heels of the decision to spin-off its Smith Barney unit into a joint venture with Morgan Stanley. The two firms have agreed to combine their brokerage operations into a joint venture to be known as Morgan Stanley Smith Barney. Under the terms of the deal, Citigroup received US$2.7 billion and 49% of the joint venture in exchange for its Smith Barney brokerage business and a couple of other units. Its share of the combined firm will be held by the new Citi Holdings.

Analysts see the joint venture as both evidence of the ongoing pressure Citi Holdings and similar firms are facing and a possible sign of the government influencing the firms’ strategic direction. And there may be more of that government influence to come. In addition to splitting up Citigroup, Citi Holdings has announced that it has entered into a loss-sharing program with the U.S. government covering a US$301-billion pool of troubled assets.

These latest developments highlight the fact that the U.S. banking industry has yet to escape its fundamental problem of declining asset values leading to rising capital needs. In a recent research report, analysts at New York-based Oppenheimer & Co. Inc. foresee even more of this in the year ahead.

The Oppenheimer report notes that as rating agencies downgrade securities, banks are required to boost their risk-based capital allocations: “As fundamentals continue to devolve, more voids will be created in banks’ core capital positions (even inclusive of new TARP infusions), and we believe the banks will once again have to raise fresh capital in 2009.”

A report from Boston-based economic research firm Global Insight Inc. estimates that between US$200 billion and US$250 billion in additional capital will be needed to stabilize U.S. banks’ capital positions over the next few fiscal quarters. The report maintains that the TARP has been successful in preventing a more severe credit crunch. Yet, it notes: “The main problem that we are dealing with now is a rapidly deteriorating economic environment that is putting additional downward pressure on bank capital.”

With private sources of capital having virtually disappeared in the U.S., the report adds, continued infusions from the government are the only way to fight the ongoing erosion of bank capital.

In Canada, these pressures have been much less intense, but our banks are, nevertheless, still feeling the effects of the credit crunch. They still face possible asset losses of their own, which, coupled with the rising cost of wholesale funding, means the operating environment for banks has certainly become tougher in Canada, too. A recent research report from Credit Suisse Securities (Canada), Inc. notes: “Money was simply unrealistically cheap for too long and banks are now just waking up to the new reality.”

At the same time, Canadian banks are facing a deteriorating credit climate. “The banks are only in the third inning of the credit cycle,” the Credit Suisse report suggests, “as impaired loans are set to sharply rise in 2009.”

As a result, the Credit Suisse report says, analysts expect continued balance sheet deleveraging, no dividend growth and more new capital issues in 2009.

Indeed, a recent research report from Montreal-based Desjardins Securities Inc. notes the Canadian banks have recently been scrambling to bolster their non-common equity Tier 1 capital. While some of the pressure to do this is likely coming from the market, the report cites another reason: “It is also due to the mounting pressure of ‘potholes’ on bank balance sheets created by unrealized net losses on their available-for-sale debt securities.”

While the capital raised in the market by Canadian banks plays the same basic role as capital injected by taxpayers, keeping the government out of the boardroom probably leaves the domestic banks better positioned once financial markets finally return to normal.

The “perfect storm” may have passed through financial markets this past fall, but it appears that the financial services industry will be digging out from its effects for some time to come. IE