Possible ways to overcome the financial crisis

      For responsible governments and institutions around the world, this situation poses two essential problems:       First, how to survive under conditions of a chaotic monetary breakdown crisis, including the possibility of wild currency fluctuations and breakdown of payments systems, which could make trade and even ordinary business operations virtually impossible.      Second, how to create a new global financial and monetary system, suited to the requirements of survival and real development, to replace the old one.

     The government’s ability to deal efficiently with financial crisis can be improved by establishing an effective regulatory body in order to reduce high-risk lending practices of financial institutions.  An effective regulatory body alone will not be sufficient to deal with financial crisis. Providing liquidity by IMF would prevent contagion and speculative attacks, but may increase the risk-taking of financial institutions without the proper regulatory body.  If the IMF becomes the lender of last resort, then local authorities may have fewer incentives to create strong financial regulatory bodies since local authorities do not have to pay the full cost of the financial crisis.  The current system of constructive ambiguity prevents local authorities from creating intentionally weak regulatory financial bodies.  Also, the risk-based system of contribution by countries to IMF may help alleviate the problem of weak financial regulations.      

Bail-out banks that are solvent but illiquid may prevent wider financial panics that destroy viable banks.  Creditors need to be concerned and need to help developing countries in protecting potential productive investment projects from being halted during a financial crisis.  Also, creditors need to help provide liquidity to meet short term obligations and help reschedule the debt.    

Keeping proportion of short term financial capital inflows in non-interest bearing accounts for a given period of time or imposing taxes on the financial inflows or both represent high cost for short term financial inflows, but small costs for long term financial investment.  The above two methods of regulation may help prevent local financial institutions from relying too heavily on foreign financial capital inflows to fund long term local lending, which is one of the reasons for financial crisis.    

Limiting the percentage of long-term loans granted and held by local financial institutions to a level is helpful in preventing speculative currency attack.  The above restriction does not eliminate financial crisis but may reduce its probability. Still, the major reason for financial crisis is the mismatch of maturity.  The heavy reliance of local banks on rollover short-term foreign funds and the reliance of local corporations on borrowing from abroad on loans denominated in foreign currency would be a recipe for disaster if capital inflow reverses direction.  Building up large amounts of foreign reserves makes a country less vulnerable to speculative attack.  But the problem facing most developing countries is the lack of ability to do so.     

Allowing foreign banks to operate in the developing countries may reduce the cost of the bail-out of the local banks in the event of a financial crisis.  But the local depositors in foreign-owned banks would suffer without a bail out of the branches of foreign banks. Opening the banking sector to foreign participation would increase the safety of the local banking sector. Also there is a realistic fear that foreign banks may not lend money to needy small businesses.  Developing countries need to encourage their banking to expand beyond their borders.  This expansion may reduce the uncertainty associated with their small economy.  However, this expansion of local banks beyond one country may reduce the volatility of the banking sector; it can also create exchange rate risk.