Reserve accumulation and financial stability

By Maurice Obstfeld, Jay C. Shambaugh and Alan M. Taylor

Economists’ Forum, 14 de octubre del 2008

Since the early 1990s, central banks in many emerging markets and developing countries have accumulated foreign reserves at an unprecedented rate. The macroeconomic impact of these official flows has been profound and they have contributed significantly to global imbalances. Providing an explanation for these trends remains a major puzzle in international macroeconomics, and prevailing theories based on trade or debt deliver poor empirical performance. We argue that part of this great reserve accumulation is a response to the threat of financial instability in the context of rapidly expanding financial systems, increasingly mobile capital, and exchange rate objectives. The recent turbulence in global financial markets supports this view.

In the 1980s, the monetary authorities in both industrial and developing countries maintained a fairly steady and consistent level of foreign reserves, at about 4 percent of GDP. After 1990, the trends in the two groups of countries diverged, and a great accumulation of reserves began in the emerging market countries, which by 2005 had accumulated reserves in excess of $2 trillion representing more than 20 percent of their collective GDP (Figure 1).

Why have the central banks of emerging markets and developing countries accumulated such large hoards of foreign reserves? This question remains one of the great puzzles of contemporary international macroeconomics.

For example, in the realm of theoretical work, Jeanne (2007) found it difficult to reconcile the magnitude of current reserve holdings with a model where countries need a buffer to insure against a “sudden stop” in capital flows that might expose them to consumption risk, unless one assumes that the cost of a crisis is implausibly large. In the realm of empirical work, influential papers by Joshua Aizenman and co-authors (2003, 2007) have shown some success. Most empirical models of reserve-to-GDP ratios have tended to rely on the “traditional” explanatory variables such as trade-to-GDP ratios (the rule since the Bretton Woods era being enough reserves to finance three months of imports). Traditional measures such as this were joined in the 1990s by “new” explanatory variables such as the ratio of short-term debt to GDP (based on the so-called Guidotti-Greenspan rule of thumb).

Still, even the augmented empirical models tend to underpredict reserve levels, especially in the more recent years since the wave of emerging-market crises of the late 1990s. That led the IMF (2003) to conclude that existing models could be judged a failure. The motives for the recent reserve build-up therefore remain open to debate and the subject of great controversy. If reserve levels are “too high” relative to any reasonable benchmark, then the case can be made that countries are squandering valuable resources on low yielding assets that could be better invested elsewhere (Summers 2006; Rodrik 2006).

Financial stability and the trilemma

Central banks have multiple responsibilities that go beyond concerns for price stability (and, to a greater or lesser degree, for output and employment). As recently noted by Charles Goodhart on Vox-and as recent events in developed economies have reminded us-central banks also have the frontline responsibility for financial stability. Unlike treasury departments or financial regulators, it is central banks that have the unique capacity to supply liquidity rapidly and plentifully in the event of a banking crisis. How can central banks fulfill their responsibilities under the conditions that prevail in typical emerging market countries today?

In a new paper , we argue that three crucial factors have forcefully coincided since 1990 to expose emerging markets to a much greater risk of crises that take the form of a classic “double drain” from bank deposits to cash, and then from cash to hard currency. These factors are:

1. A continuing desire to maintain a policy of fixed (or tightly managed) exchange rates, or a “fear of floating” (Calvo and Reinhart 2002), whether to provide a transparent and credible nominal anchor, to boost trade (Klein and Shambaugh 2006), or to avert destabilizing balance sheet shocks when liabilities are dollarized.

2. An ongoing trend, related to economic development, toward an increasingly monetized economy with a larger domestic banking and financial system relative to GDP (Demirgüç-Kunt and Levine 2001).

3. A new inclination to shift policy so as to liberalize external financial flows. This liberalizing trend is seen as complementary with a deepening of domestic financial markets (Obstfeld forthcoming).

The potential risk of a financial storm combining these three elements has long been recognized. For examples, as well as some theoretical intuition and potential policy responses, we can look back in history, both distant and recent.

Britain, 1797 and 2007 In 1797 a bank run during the Napoleonic wars saw the Bank of England issue paper credit as a dernier resort to ailing country banks. However, the public desired not paper, but gold, and as the paper came back to Threadneedle Street, the Bank’s stock of gold proved insufficient to cover the drain. The Bank was forced to “stop payment”-that is, suspend the gold standard-and let the exchange rate float. Henry Thornton, in his seminal work Paper Credit, faulted the Old Lady for holding insufficient gold to allay such a “fright”; he also argued that a policy of credit contraction might only make fundamentals worse in the short run, amplifying the risk of crisis. The only safe approach was to accumulate a large war chest of reserves ex ante.

The most recent Bank of England crisis (Northern Rock, 2007) serves to illustrate the unconstrained ability of a developed country central bank to intervene for financial stability purposes when the pound is floating: there is no exchange rate peg to worry about, no reserves to manage. The value of the pound could absorb any shock due to money creation, so the Bank could issue unlimited liquidity support.

Argentina, 1994 and 2001 In December 1994 the Mexican “Tequila Crisis” reverberated across emerging markets and Argentina, then on a pseudo-currency board peg, faced a sudden stop in capital markets and a double drain. The currency stock M0 held steady, but broad money M2 collapsed as depositors fled for Miami and Montevideo. By early 1995 reserves had fallen by about half as the central bank extended liquidity support to domestic banks. The IMF, previously reluctant to lend to Argentina, relented, allowing the country to replenish its reserves. At that point private capital flows resumed, but it was a close shave.

Argentina had no such luck in 2001, when suffering from even worse macroeconomic fundamentals. Over the course of the year to October more than $10 billion in reserves bled out as M2 fled into foreign currency. In November negotiations with the IMF collapsed, no reserves could be borrowed, and the sudden stop was complete. The reserve drain jumped to $1 billion per day, and after 48 hours the capital controls of the corralito put an end to the convertibility plan. By early 2002 the peso was floating at one third to one quarter of its former $1 par value.

These examples illustrate the vexing problems faced by monetary authorities as they navigate between the macroeconomic policy trilemma and the goal of insuring financial stability. Emerging markets with pegs and exposure to sudden stops face a larger risk of crisis the smaller are their reserve holdings, holding constant the size of any flight shock. Under a fixed exchange rate and capital mobility, there is no space for monetary policy autonomy. In previous work we have shown that this applied to interest rate policy (Obstfeld, Shambaugh, and Taylor 2004; 2005). But we now argue that the same constraints affect the reserve cushions needed to weather banking crises.

What the Data Show

We examine a panel of roughly 120 countries from 1980 to 2004 to assess the empirical relevance of these ideas. We find that if we add “financial factor” regressors to a traditional empirical model, they are always economically and statistically significant. Financially open, financially deep countries with pegged exchange rates all tend to hold more reserves. Within the emerging market sample – where much of the puzzle lies – the fixed exchange rate effect is weaker, but financial depth (as measured by the ratio M2/GDP) is highly significant and growing in importance over time. Trade openness is the other robust determinant of reserve demand. We conduct a variety of tests and show that financial depth is important both in the cross-section and in the time series dimension of the data, that our results are not simply a result of a positive effect of reserve growth on money-supply growth, and that our results are robust to considering measures of debt or original sin.

We also consider the predictive power of our arguments. A traditional model of reserves leaves substantial amounts of recent reserve growth unexplained, whereas our model does not. Our model cannot explain all reserve growth (Japan’s behavior in the last decade and China’s since 2004 cannot be explained entirely by financial stability motives and trade), but the puzzle identified in the literature is much smaller when financial factors are considered.

These findings lead us to conclude that recent reserve accumulation is in part explained by concerns for financial stability in the face of open capital markets and pegged exchange rates. In future work we will try to determine whether such accumulation appears sufficient to quell fears or if, instead, it has been too large (and thus accumulation excessive even in the face of financial stability concerns).

Conclusions

Our research suggests that financial development has played a major role in stimulating precautionary reserve accumulation in emerging markets. But we argue that the precaution is not to have a buffer against the inability of domestic residents to issue new external liabilities, the typical “sudden stop” argument. Rather, the buffer is also a safeguard against the sudden wish of domestic residents to acquire new external assets-that is, “sudden flight” (Rothenberg and Warnock 2006; Calvo 2006). The greatest flight risks are posed by the most liquid assets, the liquid liabilities of the banking system, which we measured by M2 and whose growth we found to be highly correlated with reserve growth in recent times.

These forces are by no means small. In our model, the predicted level of reserve purchases by all emerging markets for 2004 was $160 billion. For comparative purposes this sum is about ¼ of that year’s U.S. current account deficit. The emerging markets have large global macro weight and their GDP growth is high. Their M2 growth is higher still. If the risk of sudden flight remains, and if a preference for exchange rate stability remains, policymakers may be expected to continue to scale up their reserves in rough proportion to M2. In that case, we are likely to see even larger reserve accumulation, and larger global imbalances, for many years to come.

Maurice Obstfeld is a Professor of economics at the University of California, Berkeley, and is Director of the Center for International and Development Economics Research. Jay C. Shambaugh is an Associate Professor of economics at Dartmouth College. Alan M. Taylor is a Professor of economics at the University of California, Davis, and is Director of the Center for the Evolution of the Global Economy

La LIBOR baja

La noticia de que el gobierno de Estados Unidos (siguiendo lo que han hecho ya Islandia, Irlanda, Alemania e Inglaterra) va a capitalizar sus bancos más grandes logró, por fin, disminuir la percepción de riesgo en el mercado interbancario; la cual había venido aumentando el spread entre la tLIBOR y los Overnight Interest Swaps.

Ayer, por fin, este spread comenzó a caer por primera vez desde agosto del año pasado cuando la Reserva Federal comenzó a tratar de inyectar liquidez en los mercados de corto plazo. Esta caída nos permite esperar, por fin, una caída en las tasas de interés en los mercados de EEUU y Europa.

Lo que estamos viendo en el fondo es que la caída esperada del riesgo ha arreglado los mecanismos de transmisión de la política monetaria. Esto permitiría que la tasa de interés overnight-la principal herramienta de la Reserva Federal- sea util de nuevo y el gobierno pueda expandir la liquidez (correr la MP a la derecha) de los agregados monetarios más ampliados. En estos casos, dado que además la inflacion en Estados Unidos es alta y hay buenas perspectivas a largo plazo, es probable que la economía de ese país salga de la trampa de liquidez en la cual estaba entrando.

A mediano plazo, en una recesión fuerte, la política monetaria no es la mejor herramienta para reactivar la inversión y el consumo (dado el riesgo referido arriba y a que usualmente ya no queda mucho espacio para bajar la tasa de interés). La función importante de la Fed en estos momentos críticos no es curar al paciente sino evitar que se muera dandole los primeros auxilios;, impidiendo un desangre de liquidez. En terminos prácticos: evitar una crísis sistémica de los bancos, mantener los sistemas de pagos funcionando y tasas bajas en los money markets.

Libor for Dollars, Euros Fall on Government Bank-Rescue Plans

By Gavin Finch and Bob Chen

Bloomberg, Oct 14

Oct. 14 (Bloomberg) — Money-market rates in London fell after the U.S. joined the U.K., Germany and France in offering to buy stakes in banks to restore confidence in the global financial system.

The London interbank offered rate, or Libor, that banks charge each other for one week dollar loans slid 50 basis points to 4.08 percent today, the biggest drop since Sept. 19, according to the British Bankers’ Association. It was at 4.76 percent on Oct. 9, the highest level since December. The three-month euro rate fell 7 basis points to 5.23 percent, the largest decline since Dec. 28.

The U.S. will invest about $125 billion in nine of the biggest banks, including Citigroup Inc. and Goldman Sachs Group Inc., in exchange for preferred shares, said people briefed on the plan. The measure follows similar moves by European leaders to unlock credit markets by helping beleaguered banks.

“What everyone was crying out for was a coordinated central policy response, and that’s what we got,” said Patrick Bennett, a currency strategist with Societe Generale SA in Hong Kong. “What we had was a lack of confidence in the money markets. I think it’s starting to thaw.”

European and U.S. governments may spend as much as $3 trillion to unfreeze credit markets, meet demand for dollars and shore up banks. The European Central Bank today offered $100 billion for one day, after yesterday agreeing with counterparts in the U.S., Canada, Switzerland and the U.K. to provide unlimited dollar funds in auctions with maturities of seven days, 28 days and 84 days at a fixed interest rate.

Equities Rebound

Stocks rose for a second day, with the MSCI World Index adding 3.6 percent to its 9.5 percent surge yesterday. Equity markets worldwide suffered their worst rout last week on concern more financial institutions would collapse because of the freeze in credit markets.

The dollar Libor-OIS spread, a gauge of demand for cash, narrowed 14 basis points to 340 basis points. It was at 105 basis points on Sept. 15 and 24 basis points on Jan. 24. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, narrowed 12 basis points to 445 basis points, down from 464 basis points on Oct. 10, the most since Bloomberg began tracking the data in 1984.

The Bush administration will also buy preferred shares in Wells Fargo & Co., JPMorgan Chase & Co., Bank of America Corp., Merrill Lynch & Co., Morgan Stanley, State Street Corp. and Bank of New York Mellon Corp., said the people briefed on the plan. The proposal is part of a $700 billion rescue approved by Congress. Countries including France, Germany, Spain and Austria yesterday committed 1.1 trillion euros ($1.5 trillion) to guarantee bank loans and take stakes in banks equal to 3 percent of their economies.

Asia Rates

Money market rates fell across Asia after Japan and Australia pumped $9.1 billion into the financial system. Singapore’s three- month dollar loan rate dropped for the first time in a week, falling 13 basis points to 4.66 percent. Japan’s borrowing costs eased to the lowest this month.

In a sign that credit-markets remain strained, banks deposited a record amount of cash with the ECB overnight, lodging 182.8 billion euros at 3.25 percent, up from 154.7 billion euros on Oct. 10. They also borrowed 17.5 billion euros from the central bank at the emergency overnight marginal rate of 4.25 percent, up from 16.6 billion euros.

While the three-month dollar rate fell 12 basis points to 4.64 percent today, it is still 314 basis points more than the Fed’s target of 1.5 percent. The difference was a record 332 basis points on Oct. 10 and 82 basis points on Sept. 15, the day Lehman Brothers Holdings Inc. collapsed.

Libor, set by 16 banks in a survey conducted by the BBA each day in London, determines rates on $360 trillion of financial products worldwide, from home loans to derivatives. Member banks provide estimates on how much it would cost to borrow in 10 currencies for terms between one day and a year.

To contact the reporters on this story: Gavin Finch in London at gfinch@bloomberg.net; Bob Chen in Hong Kong at bchen45@bloomberg.net.

Gordon Does Good

Por Paul Krugman

New York Times, 12 de octubre del 2008

Has Gordon Brown, the British prime minister, saved the world financial system?

O.K., the question is premature — we still don’t know the exact shape of the planned financial rescues in Europe or for that matter the United States, let alone whether they’ll really work. What we do know, however, is that Mr. Brown and Alistair Darling, the chancellor of the Exchequer (equivalent to our Treasury secretary), have defined the character of the worldwide rescue effort, with other wealthy nations playing catch-up.

This is an unexpected turn of events. The British government is, after all, very much a junior partner when it comes to world economic affairs. It’s true that London is one of the world’s great financial centers, but the British economy is far smaller than the U.S. economy, and the Bank of England doesn’t have anything like the influence either of the Federal Reserve or of the European Central Bank. So you don’t expect to see Britain playing a leadership role.

But the Brown government has shown itself willing to think clearly about the financial crisis, and act quickly on its conclusions. And this combination of clarity and decisiveness hasn’t been matched by any other Western government, least of all our own.

What is the nature of the crisis? The details can be insanely complex, but the basics are fairly simple. The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.

What can be done to stem the crisis? Aid to homeowners, though desirable, can’t prevent large losses on bad loans, and in any case will take effect too slowly to help in the current panic. The natural thing to do, then — and the solution adopted in many previous financial crises — is to deal with the problem of inadequate financial capital by having governments provide financial institutions with more capital in return for a share of ownership.

This sort of temporary part-nationalization, which is often referred to as an “equity injection,” is the crisis solution advocated by many economists — and sources told The Times that it was also the solution privately favored by Ben Bernanke, the Federal Reserve chairman.

But when Henry Paulson, the U.S. Treasury secretary, announced his plan for a $700 billion financial bailout, he rejected this obvious path, saying, “That’s what you do when you have failure.” Instead, he called for government purchases of toxic mortgage-backed securities, based on the theory that … actually, it never was clear what his theory was.

Meanwhile, the British government went straight to the heart of the problem — and moved to address it with stunning speed. On Wednesday, Mr. Brown’s officials announced a plan for major equity injections into British banks, backed up by guarantees on bank debt that should get lending among banks, a crucial part of the financial mechanism, running again. And the first major commitment of funds will come on Monday — five days after the plan’s announcement.

At a special European summit meeting on Sunday, the major economies of continental Europe in effect declared themselves ready to follow Britain’s lead, injecting hundreds of billions of dollars into banks while guaranteeing their debts. And whaddya know, Mr. Paulson — after arguably wasting several precious weeks — has also reversed course, and now plans to buy equity stakes rather than bad mortgage securities (although he still seems to be moving with painful slowness).

As I said, we still don’t know whether these moves will work. But policy is, finally, being driven by a clear view of what needs to be done. Which raises the question, why did that clear view have to come from London rather than Washington?

It’s hard to avoid the sense that Mr. Paulson’s initial response was distorted by ideology. Remember, he works for an administration whose philosophy of government can be summed up as “private good, public bad,” which must have made it hard to face up to the need for partial government ownership of the financial sector.

I also wonder how much the Femafication of government under President Bush contributed to Mr. Paulson’s fumble. All across the executive branch, knowledgeable professionals have been driven out; there may not have been anyone left at Treasury with the stature and background to tell Mr. Paulson that he wasn’t making sense.

Luckily for the world economy, however, Gordon Brown and his officials are making sense. And they may have shown us the way through this crisis.

U.S. Investing $250 Billion in Banks

Mark Landler, 13 de octubre del 2008, New York Times

WASHINGTON — The Treasury Department, in its boldest move yet, is expected to announce a plan on Tuesday to invest up to $250 billion in banks, according to officials. The United States is also expected to guarantee new debt issued by banks for three years — a measure meant to encourage the banks to resume lending to one another and to customers, officials said.

And the Federal Deposit Insurance Corporation will offer an unlimited guarantee on bank deposits in accounts that do not bear interest — typically those of businesses — bringing the United States in line with several European countries, which have adopted such blanket guarantees.

The Dow Jones industrial average gained 936 points, or 11 percent, the largest single-day gain in the American stock market since the 1930s. The surge stretched around the globe: in Paris and Frankfurt, stocks had their biggest one-day gains ever, responding to news of similar multibillion-dollar rescue packages by the French and German governments.

Treasury Secretary Henry M. Paulson Jr. outlined the plan to nine of the nation’s leading bankers at an afternoon meeting, officials said. He essentially told the participants that they would have to accept government investment for the good of the American financial system.

Of the $250 billion, which will come from the $700 billion bailout approved by Congress, half is to be injected into nine big banks, including Citigroup, Bank of America, Wells Fargo, Goldman Sachs and JPMorgan Chase, officials said. The other half is to go to smaller banks and thrifts. The investments will be structured so that the government can benefit from a rebound in the banks’ fortunes.

President Bush plans to announce the measures on Tuesday morning after a harrowing week in which confidence vanished in financial markets as the crisis spread worldwide and government leaders engaged in a desperate search for remedies to the spreading contagion. They are desperately seeking to curb the severity of a recession that has come to appear all but inevitable.

Over the weekend, central banks flooded the system with billions of dollars in liquidity, throwing out the traditional financial playbook in favor of a series of moves that officials hoped would get banks lending again.

European countries — including Britain, France, Germany and Spain — announced aggressive plans to guarantee bank debt, take ownership stakes in banks or prop up ailing companies with billions in taxpayer funds.

The Treasury’s plan would help the United States catch up to Europe in what has become a footrace between countries to reassure investors that their banks will not default or that other countries will not one-up their rescue plans and, in so doing, siphon off bank deposits or investment capital.

“The Europeans not only provided a blueprint, but forced our hand,” said Kenneth S. Rogoff, a professor of economics at Harvard and an adviser to John McCain, the Republican presidential candidate. “We’re trying to prevent wholesale carnage in the financial system.”

In the process, Mr. Rogoff and other experts said, the government is remaking the financial landscape in ways that would have been unimaginable a few weeks ago — taking stakes in the industry and making Washington the ultimate guarantor for banking in the United States.

But the pace of the crisis has driven events, and fissures in places as far-flung as Iceland, which suffered a wholesale collapse of its banks, persuaded officials to act far more decisively than they had previously.

“Over the weekend, I thought it could come out very badly,” said Simon Johnson, a former chief economist of the International Monetary Fund. “But we stepped back from the cliff.”

The guarantee on bank debt is similar to one announced by several European countries earlier on Monday, and is meant to unlock the lending market between banks. Banks have curtailed such lending — considered crucial to the smooth running of the financial system and the broader economy — because they fear they will not be repaid if a bank borrower runs into trouble.

But officials said they hoped the guarantee on new senior debt would have an even broader effect than an interbank lending guarantee because it should also stimulate lending to businesses.

Another part of the government’s remedy is to extend the federal deposit insurance to cover all small-business deposits. Federal regulators recently have been noticing that small-business customers, which tend to carry balances over the federal insurance limits, had been withdrawing their money from weaker banks and moving it to bigger, more stable banks.

Congress had already raised the F.D.I.C.’s deposit insurance limit to $250,000 earlier this month, extending coverage to roughly 68 percent of small-business deposits, according to estimates by Oliver Wyman, a financial services consulting firm. The new rules would cover the remaining 32 percent.

“Imposing unlimited deposit insurance doesn’t fix the underlying problem, but it does reduce the threat of overnight failures,” said Jaret Seiberg, a financial services policy analyst at the Stanford Group in Washington.

“If you reduce the threat of overnight failures,” Mr. Seiberg said, “you start to encourage lending to each other overnight, which starts to restore the normal functioning of the credit markets.”

Recapitalizing banks is not without its risks, experts warned, pointing to the example of Britain, which announced its program last week and injected its first capital into three banks on Monday.

Shares of the newly nationalized banks — Royal Bank of Scotland, HBOS and Lloyds — slumped on Monday, despite a surge in banks elsewhere, because shareholder value was diluted by the government.

The move, analysts said, makes the government Britain’s biggest banker. And it creates a two-tier banking system in which the nationalized banks are run like utilities and others are free to pursue profit growth. As part of the plan, the chief executives of the three banks stepped down.

Still, Mr. Paulson’s strategy was backed by lawmakers, including Senator Charles E. Schumer, Democrat of New York, who said he preferred capital injections to buying distressed mortgage-related assets — a proposal that Treasury pushed aggressively before its turnabout.

In a letter to Mr. Paulson on Monday, Mr. Schumer, chairman of the Joint Economic Committee, urged the Treasury to demand that banks receiving capital eliminate their dividends, restrict executive pay and stick to “safe and sustainable, rather than exotic, financial activities.”

“I don’t think making this as easy as possible for the financial institutions is the way to go,” Mr. Schumer said in a call with reporters. “You need some carrots but you also need some sticks.”

But officials said the banks would not be required to eliminate dividends, nor would the chief executives be asked to resign. They will, however, be held to strict restrictions on compensation, including a prohibition on golden parachutes and requirements to return any improper bonuses. Those rules were also part of the $700 billion bailout law passed by Congress.

The nine chief executives met in a conference room outside Mr. Paulson’s ornate office, people briefed on the meeting said. They were seated across the table from Mr. Paulson; Ben S. Bernanke, chairman of the Federal Reserve; Timothy F. Geithner, president of the Federal Reserve Bank of New York; Federal Reserve Governor Kevin M. Warsh; the chairman of the F.D.I.C., Sheila C. Bair; and the comptroller of the currency, John C. Dugan.

Among the bankers attending were Kenneth D. Lewis of Bank of America, Jamie Dimon of JPMorgan Chase, Lloyd C. Blankfein of Goldman Sachs, John J. Mack of Morgan Stanley, Vikram S. Pandit of Citigroup, Robert Kelly of Bank of New York Mellon and John A. Thain of Merrill Lynch.

Bringing together all nine executives and directing them to participate was a way to avoid stigmatizing any one bank that chose to accept the government investment.

The preferred stock that each bank will have to issue will pay special dividends, at a 5 percent interest rate that will be increased to 9 percent after five years. The government will also receive warrants worth 15 percent of the face value of the preferred stock. For instance, if the government makes a $10 billion investment, then the government will receive $1.5 billion in warrants. If the stock goes up, taxpayers will share the benefits. If the stock goes down, the warrants will be worthless.

As Treasury embarked on its recapitalization plan, it offered some details on the nuts-and-bolts of the broader bailout effort. The program’s interim head, Neel T. Kashkari, said Treasury had filled several senior posts and selected the Wall Street firm Simpson Thacher as a legal adviser.

It named an investment management consultant, Ennis Knupp, based in Chicago, to help it select asset management firms to buy distressed bank assets. And it plans to announce the firm that will serve as the program’s prime contractor, running auctions and holding assets, within the next day.

“We are working around the clock to make it happen,” said Mr. Kashkari, a former Goldman Sachs banker who has been entrusted with the job of building this operation within weeks.

As details of the American recapitalization plan emerged, fears grew over the impact on smaller countries. Iceland is discussing an aid package with the International Monetary Fund, a week after Reykjavik seized its three largest banks and shut down its stock market.

The fund also offered “technical and financial” aid to Hungary, which last week suffered a run on its currency. Prime Minister Ferenc Gyurcsany said the country would accept aid only as a last resort.

In a new report on capital flows, the Institute of International Finance projected that net capital in-flows to emerging markets would decline sharply, to $560 billion in 2009, from $900 billion last year.

In Asia, markets continued to rise on Tuesday, lifted further by the announcement that the Japanese government would inject 1 trillion yen ($9.7 billion) into the financial system.