Arnold Kling  

Healthy Banks or Healthy Markets?

Letter from Birmingham Jail... Some Random Books...

John Hempton writes,

If the bank runs for three years it will again be solvent. If it runs for less than six years it will be fully and adequately capitalised. This is in fact how the Japanese mega-banks recapitalised. I blogged about it here. At the spreads in America - which are several percent - the recapitalisation will happen much quicker than this and much quicker than in Japan. Indeed it is likely that with quasi government guarantees for bank funding and market rates for bank loans the spreads would be over five percent in America right now.

Thanks to Mark Thoma for the pointer. [UPDATE: Luis Zingales also is pondering the issue of rules and discretion.]

The performance of a financial institution depends on its cost of funds. As I pointed out in July, Freddie Mac and Fannie Mae look a lot better if their debt carries a low risk premium than if it carries a high risk premium.

What I think Hempton is saying is that if the government lends to banks for a few years using its low risk premium, then the banks will earn enough to rise out of insolvency.

Hempton's analysis raises the question: Suppose that the banks (and Freddie and Fannie) could come back if the government lent them money for a few years. Is there a public benefit in that?

Right now, the U.S. government enjoys borrowing privileges over everyone else. The spread between Treasury borrowing rates and private borrowing rates is high. Perhaps it should use those privileges to prop up banks. But perhaps there are higher rates of social return to be found elsewhere.

Ordinarily, I would want the market to decide where to invest. I think that entrepreneurial trial and error, with responsibility for failure borne primarily by the decision-makers, is the best approach.

In theory, we have a set of rules for when to close financial institutions. According to those rules, many banks should have been shut down by now.

Instead, regulators are using discretion to bail out banks. This use of discretion benefits some banks, but it makes it more difficult for other banks to compete. As a result, the risk premium paid by financial institutions rises. The higher the risk premium, the more banks get in trouble, and the more discretionary bailouts are undertaken.

I think we need to sort out the relationship between healthy banks and healthy markets. I think we could have healthy markets without healthy banks. That is, we could close a lot of banks and still have healthy markets. However, as long as the decision about what is healthy and what is not is made through weekend meetings among policymakers, private financial intermediation is bound to be driven out by government.

If we were using rules, then those rules might shut down banks that could survive if they were granted risk-free borrowing privileges by government. However, I would argue that such banks ought to be shut down. My hope is that under a system of rules, the risk differential between private and government borrowing rates eventually would narrow, so that there would not be the temptation to use the government's borrowing privilege to bail out banks.

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Walt French writes:

We should all be concerned about these issues. If a bank is insolvent, then it took risks with shareholder equity that worked out badly. I'm all in favor of letting them enjoy their full reward. Not the least because many of these shareholders enjoyed fat dividend checks for the past few years, which helped the management emphasize higher-risk lending, while not incidentally generating fat bonuses for management. This was an era where "risk was rewarded, so pile it on."

Still, if we are to nationalize virtually the entire banking system, it's not clear that it would be able to function under new shareholders (Uncle Sam & Aunt Samantha). We have strongly contradictory messages of "lend out the #*(# TARP money, dammit!" and, "don't repeat the imprudent practices that got you into this mess." It's not clear that the relatively more independent Fed has the talent, staff, etc., any more than the Federal government.

And since inter-bank lending is important, we can easily see that a Chapter-11-style disposition of banks' assets, especially a markdown of their bonds, leads to a circular firing squad, with each "haircut" to a few lenders causing them to fail, too. Yet bondholders took risks that look imprudent, too; we will continue to promote the moral hazard that caused the mess if we give them a free ride.

Seems that if we want to set a fair and helpful recovery program, we want to identify the nature of regulation, limits and mandatory insurance payments we expect of banks, and to work towards those goals. Otherwise we'll just be fighting fires for a few years until we run out of energy and punt the ball yet again. Next guy who proposes what we should do to fix the mess ought to be asked how that will help us move to a better regulatory regime going forward.

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