This crisis marks the reversal of a decades-long transition from a bank-dominated to a market-dominated financial system. The market-based model has the potential to price risk and to allocate capital more efficiently. In some cases, however, the development of markets ran well ahead of the supporting infrastructure. A system that appeared resilient (and enormously profitable) in times of low volatility has proven brittle in the face of shocks.
In many parts of the world, market-based finance has weakened core financial institutions and put large non-bank financial sectors under great strain. Certain markets are now frozen. Consequently, there is a sudden re-emphasis on bank-based intermediation that has led to an urgent need for banks to raise very large amounts of capital. This threatens to intensify the global economic slowdown if not managed properly.
We must ensure that banks continue to lend. We must also ensure that core markets – such as interbank lending, commercial paper and repo markets for high-quality securities – are kept continuously open. There are two related strategies to achieve these imperatives.