Government bailouts of stricken banks and institutions have been a hot topic in the media since the summer of 2007, and have aroused mixed feelings among politicians, bankers and the general public alike, ranging from stoicism to suspicion. “It is important to recall that we only have a very limited knowledge of many aspects of the financial crisis,” says Yves Mersch, Governor of the Central Bank of Luxembourg.

One aspect that is sure, however, is the need to explore alternative actions to liquidity injections from governments and central banks, which can create issues of moral hazard.

Losses accrued through excessive risk-taking can be papered over, and attitudes towards risk itself can be equally cavalier. This fosters a mentality that loss is acceptable because while profits can be enjoyed when times are good, when losses are made, people can get complacent and believe they will be bailed out in an emergency.

Enhancing resilience

The burden on governments has been heavy, according to Mersch, “so far, Eurozone governments have committed approximately 26% of GDP to the financial sector in this time of crisis, although this support was necessary.” Necessary it may have been, and the ultimate consequences are positive in economic terms, but the challenge for the future is to find alternative methods for lean times, believes Mersch. “There are signs of improvement, but these are relative to twelve months ago, not three years ago, but exit strategies must be considered.”

Among the aspects Mersch sees as vital are a more thorough approach to systemic risk and a mentality favouring long-term stability over short-term profit. “We need improved cooperation in surveillance and oversight,” Mersch continues, “systemic risk analysis was a key absence in the run up to the crisis, and there is something of a paradoxical situation whereby individual banks can appear stable, but the market, the banking system as a whole, is not.”

Can systems be infallible? “Crises are an inevitable part of the financial world. It would be misguided to think they can be eliminated completely. What we do have to do is prepare adequately. Many changes need to be implemented: extraordinary policy measures taken were required to avoid the total collapse of the financial system. Hopefully the ongoing process of financial reform will enhance resilience and reduce the need for such interventions.”

“There are often difficulties in finding names for things. We decided to go with Coercs, which stands for Call Option Enhanced Reverse Convertibles,” smiles Theo Vermaelen, professor at Insead and the Luxembourg School of Finance (LSF), of the policy mechanism he and Christian Wolff have proposed. The idea here is that Coercs can save the banks (for example) without using tax-payers’ money. Put simply, a Coerc is an example of contingent capital, where debt is converted into equity after a certain triggering event, “when the market value hits a specific level,” says Vermaelen, “and acts as an alternative, or a compliment to regulation.

Effectively, it is a contract that forces a recapitalisation at the moment a company gets into trouble.” By avoiding involuntary intervention on the part of the tax payer, the system of transferring debt to equity places less strain on governments, something that has been an issue over the past while.

In terms of manipulation, Coercs can sidestep this issue because the target event is pre-defined, and equity holders have the right to buy back shares from bondholders in the case of debt.

As Mersch says, crises are inevitable: what is a key issue for the future is what options there are for the financial sector. Unnecessary strain on the tax-payer is best avoided, that is clear. Coercs provide an alternative, but surveillance and reporting must be improved. A wider range of tools to counteract obstacles is needed. We may not know everything about the crisis, but we do know that information must be improved, and alternative options must be considered.