Our current economic dilemma has two key components: the credit squeeze and capitalization problems at the banks. In turn, these have led to a slowing global economy.

There has been considerable interdependence between these factors. For example, the credit squeeze meant that banks were finding it next to impossible to re-capitalize. That’s why governments in many countries stepped in to provide extra equity. If they had not, then banks would have been forced to call in loans, lower credit lines, reduce overdraft protection and generally raise borrowing costs.

One of the next scenes in this drama will be a push to establish international regulation and oversight to replace piecemeal agencies from country to country. Increasing regulation will be in three key areas.

First, there is likely to be a push to rein in executive salaries (and bonuses) in the financial sector, with a particular eye towards removing incentive plans that encourage risky speculation and a fiddling with the books to yield the best short-term results.

Second, will be a move to eliminate off-balance-sheet transactions. These were the collateralized debt instruments (largely based on subprime mortgages) that required no capital backing and got the investment banks into such trouble.

Third will be a review of whether fair market value accounting practices (a.k.a. “mark-to-market” valuation of assets) exacerbated the problems that certain financial institutions encountered. Do they reinforce a spiralling down in share prices when the economy sours? This may require an adjustment in accounting practices.

I suspect that it will be quickly determined that capital markets still require the kinds of grease to the system that are provided by derivatives and short selling as undertaken by hedge funds in order to achieve the greatest efficiencies.

As a final note, the huge U.S. financial sector may be a somewhat reluctant participant when it comes to these new international initiatives.

Alex Carrick

Find Canadian construction-related economic articles in Canadian Construction Market News and in the Economic Outlook section of Daily Commercial News.

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