Are things improving or are they getting worse?

LIBOR, the gauge for how much banks charge to lend to each other, continued to inch down last week. The three-month London Interbank Offered Rate dropped to its lowest level since the collapse of Lehman Brothers Holdings Inc. on Sept. 15. As of Oct. 22, the three-month LIBOR had dropped to 3.54%. The overnight dollar rate slid to 1.12%, the lowest level since June 2004. Perhaps most importantly, the difference between LIBOR and the rate on three-month U.S. Treasury bills, known as the TED spread, stood at 250 basis points Oct. 22, down from 434 basis points a week earlier.

All that was good news, a sign that frozen credit markets might be thawing. But, as with so many steps forward in the current financial crisis, it was followed by another hard tumble in the stock markets. The same day, the Dow Jones Industrial Average plunged to a five-year low on expectations that a global recession may be deep and long. The tenuousness of the situation was further highlighted when President Bush summoned the heads of the G20 countries to Washington for a Nov. 15 summit on the crisis.

Believe it or not, says Keith Leggett, a senior economist at the American Bankers Association, "we are seeing good news, some evidence credit markets are starting to soften. Not only is LIBOR falling, but yields on Treasuries are starting to rise, which also is a positive for banks, because we're not having the flight to safety we saw at the end of last month and the beginning of this month."

LIBOR rates and the TED spread spiked after Lehman's collapse, causing credit markets to seize up and prompting the U.S. Treasury Department and finance ministers around the world to pump trillions of dollars into the global banking system.

The drop in LIBOR should be an indication those measures are starting to work, but the credit markets are a long way from being sound. LIBOR rates still remain elevated, and the TED spread remains much wider than bankers are comfortable with. Historically, bankers have wanted the spread to be 30 to 50 basis points.

"Right now the financial system is still very fragile," ABA's Leggett says. "All we need is an event that spooks the market, such as if a large player fails. That would be enough to cause markets to seize up again."

Last week, worse-than-expected third-quarter results at five large regional banks cast a light on how much pressure remains on banks. Cleveland-based National City Corp. reported a worse-than-expected $5.15 billion loss and announced it will cut 4,000 jobs. Crosstown rival KeyCorp also reported a loss, as did Cincinnati-based Fifth Third Bancorp. Minneapolis-based U.S. Bancorp's profit fell 47%, to $576 million, as it made a bigger increase in provisions for loan losses. Birmingham, Ala.-based Regions Financial Corp. reported that net income dropped 80%.

The lingering weakness in the industry has been only partially removed by the capital infusions carried out by the Treasury. People are still wary of federal regulators' intentions because of their erratic performance during the crisis, Leggett says. When the Treasury intervened with Bear Stearns Cos., it made Bear's bondholders whole but wiped out shareholders. "That was the model people thought would be followed," he says. "The Bear Stearns rescue created a perverse incentive to buy debt because it said bondholders don't have to worry." Consequently, the shift to debt exacerbated the plunge in the stock market.

When Lehman fell, Treasury changed the model and let both shareholders and bondholders take huge losses. Since then, investors and lenders have had nowhere they could feel safe besides cash.

Fragile as the system remains, Leggett doesn't take the continuing struggles as a sign that Treasury's infusions won't ultimately be successful. "We didn't get into this problem overnight, and when you look at how we're going to get healthy, that's not going to happen overnight either," he says. "Each day that LIBOR gets lower and the spread gets narrower is an additional sign the patient is getting healthier, but it's going to be a slow process."

Other banking lobbyists add that banks' increasing willingness to lend to each other won't quickly translate into an easing of credit for the overall economy, given the downturn in business overall. Even if interbank lending increases, a recession isn't the best time for dishing out credit.

Last week some of the nation's top economists gave lawmakers a long list of suggested regulatory changes that might prevent future bubbles from getting out of hand. Former Federal Reserve Board Gov. Alice Rivlin called for more limits on subprime lending. "I would get rid of teaser rates, penalties for prepayment and interest-only mortgages." She also supported higher capital requirements for financial institutions "that have any claim on federal help if they are in danger of failing." Credit ratings agencies should be compensated by buyers of securities rather than by the companies issuing securities to prevent the credit raters from getting too cozy with the firms they grade. Rivlin, appointed to the Fed by President Clinton, also endorses beefing up the Securities and Exchange Commission and the Federal Reserve rather than undertaking a wholesale consolidation of the various banking and market regulators as the Treasury Department has proposed. "I don't think neatening up the organization chart deserves high priority."

Manuel Johnson, a Reagan-era Fed governor, also calls for better staffing of the SEC, the Fed and other supervisory agencies. He says the SEC is so short-staffed that it cannot meet such basic goals as reviewing each public company's annual report once every three years. At the Fed, oversight has been so stretched that supervisors were "oblivious" to banks' exposure to off-balance-sheet instruments such as special investment vehicles. Avoiding such obliviousness will be ever more important if the Fed settles into a role as an über-financial regulator.

Nobel Prize-winning economist Joseph Stiglitz urges creation of a financial products safety commission to review and approve products sold by highly regulated financial institutions. Regulators should encourage a move to standardized instruments and away from "tailor-made products." Many observers say one cause of the current crisis has been customized credit default swaps carrying risk that is difficult to assess. Stock options and other elements of executive compensation should have better transparency. Stiglitz also urges that executive compensation incentives be based on long-term performance -- covering at least five years -- and including strong clawback provisions.

Regarding mortgage securitization, Stiglitz thinks originators should retain at least a 20% equity stake in loans they originate to boost the incentive for sound underwriting. He also calls for limits on the pace at which banks can expand their loan portfolios. "Very rapid rates of expansion are typically a sign of inadequate screening," he says.

The economists challenge the assumption that mark-to-market accounting should be tossed out for distorting bank balance sheets. Companies were required to book financial assets at fair value beginning last year. Previously, financial assets were booked according to historical cost -- the original price paid for the asset.

Deteriorating home prices and the resulting uncertainty over the value of credit default swaps and other housing-backed financial instruments caused markets for those securities to evaporate. Nearly all of the major investment banks and many commercial banks had taken huge positions in those instruments and were forced to book huge losses. The resulting desperation to offset the balance-sheet devastation with new capital may have been unnecessary, the critics say, because the bulk of the securities are expected to regain their value over the long term.

Stiglitz says during financial turmoil it would be appropriate to substitute some other measurement for assets that have no market.

Joel Seligman, president of the University of Rochester and board member of the Financial Industry Regulatory Authority, says lawmakers should be wary of alternatives to the market as a pricing mechanism. Believing "there is some other intrinsic value other than the market can lead to excessive exuberance, excessive ebullience, in ways that can mislead you terribly," the former securities lawyer says.

Congressional Democrats appear willing to compromise with critics of fair value accounting. Rather than dump the rules, they may soften the regulatory consequences of balance sheet swings during market turmoil. For instance, financial institutions might be relieved of the need to raise more capital when markets lock up for particular long-term assets.

Fair value accounting, otherwise known as mark-to-market, has been blamed by business and many Republicans for wreaking havoc on financial firms' balance sheets following the collapse of the housing boom. Ditching fair value rules has become a rallying cry for Republicans, but Democrats have opposed such a move, arguing that mark-to-market requirements prevent companies from inflating assets and hiding financial problems.

But the Democrats are now offering to meet fair value's corporate critics in the middle by removing harsh regulatory consequences triggered by sharp declines in asset prices.

"There is a consensus forming about a two-step process," House Financial Services Committee Chairman Barney Frank, D-Mass., said during last week's hearing. "Mark-to-market is one thing, but automatic consequences that result from that are a separate thing," he said. "We should have mark-to-market, but then we should have flexibility on the consequences."

Working out the details of a consensus will be part of Frank's agenda next year.

Small bankers worry that virtually no policymakers are focusing on the potential risks posed by the four gargantuan banks that have been forged during the crisis. Bank of America Corp., J.P. Morgan Chase & Co., Wells Fargo & Co. and Citigroup Inc. now dwarf the rest of the industry after gobbling up other struggling large players with either federal encouragement or financial assistance. Michael Washburn, president and CEO of Red Mountain Bank in Hoover, Ala., told Frank's committee that the handful of big banks already too big to fail are now bigger, more concentrated. He said they pose an even greater risk to the financial system.

"Government interventions necessitated by the too-big-to-fail policy have exacerbated rather than abated the long-term problems in our financial structure," he said. Washburn, who was representing the Independent Community Bankers of America, noted that 40% of the nation's deposits and more than 50% of assets are now in the hands of those four banks. "Putting such excessive and concentrated power in the hands of just four banking executives is dangerous and unhealthy," he said.

Washburn called on Congress to force those institutions to sell enough assets "so that they cease to pose a systemic risk to the deposit insurance fund and our economy." Failing that, ICBA says regulators should impose a tiered regulatory system that subjects the biggest banks to more rigorous supervision and regulation. Specifically, the group wants them to face continuous examination, more rigorous capital requirements and to pay an added "risk premium" in addition to the assessment they already pay to the Federal Deposit Insurance Corp.'s deposit insurance fund.

Rivlin says that although she supports new financial rules to stem the kind of behavior that inflamed the current meltdown, it would be wrong to blame misdeeds for most of America's financial problems. "Malfeasance and even regulatory failure played a relatively small role," she says. America, she and others argue, has been living beyond its means. "We've been spending too much, saving too little and borrowing without concern for the future from whomever would support our overconsumption habit -- the mortgage companies, the new credit card or the Chinese government."

It's too easy to blame the housing bubble on reckless expansion of complex securities like credit default swaps. "Too many people failed to ask commonsense questions, as in 'What will happen to the value of these mortgage-based securities when housing prices stop rising and begin to fall?' They didn't ask because they were profiting hugely from the collective delusion and did not want to hear the answers," she says.

Her sentiments are echoed by Stiglitz. "How can there be a restoration of confidence when all we have done is to pour more money into the banks?" he asked the House Financial Services Committee last week. "We have simply given them more money to lend recklessly."

The housing boom was only the latest example of the misallocation of capital and transfer of huge risks to ordinary Americans. "These problems have occurred repeatedly and are pervasive evidence that the problems are systemic and systematic," he says.