Arnold Kling  

The Best Policy Regarding Banks

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John M. Berry writes,

At some point, politicians are going to have to stop pandering to their constituents and show leadership by explaining why the economy can't survive without a banking system.

Hear we go again. We hear a rising chorus of cheerleaders for "recapitalizing" banks. Instead, let me remind readers of the first suggestion I made, way back in September. That is, the regulators should make use of capital forbearance for solvent banks and close insolvent banks.

Are the banks that are in trouble insolvent or illiquid? If they are illiquid, then capital forbearance would keep them going. Capital forbearance means lowering the capital requirements for the banks to remain in business and to continue low-risk lending.

If the banks are insolvent, then throwing more capital at them is the infamous zombie bank strategy. Propping up zombie banks encourages them to continue to lose money, make risky bets, and make it harder for healthy banks to compete.

The regulators may whine that the "toxic assets" are hard to value, making solvency difficult to determine. However, I think that triage is possible. Based on the best estimates of the value of "toxic assets," classify banks as either healthy, insolvent, or somewhere in between. If they are insolvent, close them. If they are somewhere in between, give them capital forbearance, but put them on a tight regulatory leash otherwise. Limit their ongoing asset acquisition to low-risk lending. When the dust settles, presumably some of these banks will turn out to be healthy. The rest will cost the taxpayers some money, but presumably the tight regulatory leash will keep the banks from adding to their (our) losses.

It may be a bad idea to try to survive without a banking system. Trying to survive with a banking system that consists of insolvent banks artificially propped up by the taxpayers is an even worse idea.

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COMMENTS (7 to date)
Mick writes:

There is no price for the toxic assets. Its like asking about the price of unicorn meat, these assets are unsellable on any free exchange.

Rather than thinking of price, think about how much money these banks need straight up to function. I don't see the technical problem with the government just giving these guys giant wads of money without the pretense of buying anything.

E. Barandiaran writes:


Most likely my comment will be again deleted, but since now you're very worried about the nonsense of capitalization or nationalization, let me insist on what I said last September against your proposal and in favor of my proposal.

Thanks to Paulson, Bernanke, Geithner & Co., the situation today is much worst than at the end of September. The fundamental problem of determining which banks are "insolvent" can be solved only by giving appropriate incentives to bank managers (please note that any accounting exercise will lead to whatever bank classification you want). The incentives should be structured in such a way that bank managers will earn money and power only if they succeed in a reasonable time to comply with the current capital requirements. Those incentives should be embedded in the terms and conditions of the assets that the Treasury buys from the banks, starting with the condition that all the assets sold to the Treasury should be repurchased by the banks before their managers can collect any reward.

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8 writes:

I can't find the link now, but John Mauldin talked about hedge funds taking over some of the role of banks and moving into the riskier segments of the credit market. I think he said the hedge fund would act like a bank, borrowing short and lending long, but the impaired banks would be unable to make these loans.

Isn't that all a bank is though? Get a bunch of capital, borrow short and lend long. There was even an article recently about how (relatively) easy it is to start a bank, just complete the paperwork. The faster the banks fail, the faster companies turn to alternative lenders, the faster the industry adapts and reforms. There's just too great of a demand for credit in the economy.

Richard writes:

It seems to me that the comments of Mick and Barandirian make sense. As I understand the toxic assets, it is those actually bad loans inculded in the various tranches of ABS. Someday these actually bad loans will be liquidated and reflected in a realized transaction not an estimated reserve for potentially bad loans. It seems to me that the US economy can absorb this actual realized loss without causing a depression. In the meantime politicians and regulators need to (1) promote confidence in our system and (2) provide liquidity, where essential, to the system. The suggestions of the two commentators would seem to satisfy this without causing the immediate financial pain to creditors and equity holders that a Lehman wipeout has produced or a BankAmerica and Citibank wipeout would produce.

Brian Shriver writes:

I like Buffett's idea of asking banks to sell 5% or so of assets with uncertain value in order to get a price estimate. This could facilitate the triage process.

Of course the insolvent banks would complain, but....

Walt French writes:

"Forbearance" recalls, for this reader, its use in Akerlof & Romer's 1994 paper on financial crises, helpfully titled, "Looting..." A&R, IIRC, found that forbearance increased the bailout cost by about half. It provided more wealth transfer opportunities for management that was divorced from proper supervision (usually, thru an ignorant, complicit or compromised Board, tho government ownership also has risks).

Much of the looting was arguably not illegal, just short-term gaming the bonus payout formulas, at opposite purpose to shareholders' and the public's interests. Sound familiar? Firms that have been only semi-systematically plundered or where financial types have managed to bury certain losses deep enough in the balance sheet, hardly seem like the firms to which we want to give more rope and less regulation.

One would normally expect that slippery standards multiply the moral hazards of political decision-making, probably what you're warning against. It's odd-- FDIC takeovers seem to have a pretty clean history.

So I guess that the challenge is that there are *so*many* banks that took "reasonable" risks, paid big bonuses (and hush money dividends) while the good times rolled, and now find themselves hollowed out under conditions, such as housing prices, that only seem stressful when compared to the bubble we are still exiting. That's quite a bit different than claiming that there are lots of good banks that are just a little squeezed until their mortgages all mature without any more defaults.

Bill Woolsey writes:

What does Kling mean by "closing" insolvent banks?

To me, that means an FDIC takevoer. After an FDIC takeover, there are three possibilities--

1. Literally shutting the doors, cutting checks for insured depositors, and liquidating assets. Once that is completed (in the distant future) everyone to whom the bank owned money, uninsured depositors and the rest, would be paid off proportionally (well, according to their contracts.)

2. Purchase and assumption. The bank stays open but with new private ownership.
a. The new ownership is another troubled bank of questionable solvency and the reorganized bank still has toxic assets on its books. FDIC has sold a combination of good and toxic assets to a bank that already has its own set of good and toxic assets. (The Citibank-Wachovia merger?)
b. The new ownership is not tied to troubled banks and the reorganized bank is free of toxic assets and has total assets greater than liabilities.

3. FDIC ownership. The bank stays open, but FDIC is the owner. This can be temporary--until the system as a whole can stand option 1, because there are sound banks ready to take on the business, or else, 2b, because there is a need for more sound banks.

I think 2b is the best option right now with 3 second best, going to 2b as soon as possible. If 1 is the most efficient, then let the private owners of a bank sell off its assets piecemeal and pay off its deposits.

Banks that are solvent, on other the other hand fall into two classes. Some meet capital requirements and others don't.

There is nothing sacred about current capital requirements. If there is a real shortage of bank credit, so that sound lending is profitable and sound banks are expending, then reducing capital requirements might well be a good idea.

If banks are shrinking lending to meet capital requirements because they have written off bad loans, and they remain solvent, then perhaps relaxing capital requirements are appropriate.
The capital that was held before the losses has done its "job." I don't see that rapidly replenishing capital is necessary or sensible.

However, the long term goal (to me, anyway) is obvious. Sound banks should expand at the expense of unsound banks providing the amount of real intermediation necessary.

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