Arnold Kling  

Systemic Risk, Seen and Unseen

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James Kwak writes,


Once investors figure out that bank debt is not safe, they will refuse to lend to any banks, and we are back in September all over again.

Nonetheless, I think that zombie banks are create more unseen systemic risk and the systemic risk that you can see by allowing bank creditors to lose money. The zombie banks compete with the healthy banks.

Tyler Cowen says that it's "pick your poison." The poison I would pick would be to shut down insolvent banks and if necessary provide short-term loans to solvent banks. Giving the short-term loans to the insolvent banks makes things worse, not better.


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COMMENTS (9 to date)
Art Deco writes:

IIRC, the anxiety in September concerned the quantum of outstanding commercial paper, commercial paper issuances, and interest-rate spreads on commercial paper and interbank lending. Per Federal Reserve data, commercial paper outstanding and rates (as opposed to rate spreads) on commercial paper are statistics that vary considerably over time. Much of the discussion at the time over the (20%) contraction in commercial paper outstanding seemed de trop.

If I understand correctly, Prof. Zingales has suggested exchanging long-term debt for equity. Mr. Kwak's concerns seem somewhat misplaced. There is already considerable anxiety that the four banks in question cannot meet their obligations, new issuances of securitized credit-card debt have already imploded (per the Wall Street Journal), and the running complaint about mortgage-backed securities is that they are illiquid. To what degree could any of the banks in question sucessfully issue corporate bonds that were not FDIC guaranteed? It seems that that which he fears has already happened.

ionides writes:

"Nonetheless, I think that zombie banks are create more unseen systemic risk and the systemic risk that you can see by allowing bank creditors to lose money."

Is there something wrong with this sentence? It doesn't seem to parse.

Adam writes:

Amen. There is excess capacity in banking. Excess capacity leads to losses until the sector shrinks. The thing to do is to shut down the insolvent banks. Hasn't this been obvious since at least early 2008?

I really don't see any policy that solves the problem of excess capacity and the incumbent losses except shutting down the insolvent banks. Since this isn't the policy that's being followed, our current policies must be dictated by public choice aimed at saving the hides and fortunes of politically favored special interests.

Ed Hanson writes:

If I had a vote right now, I would come down on your on your side, Arnold, shut down insolvent banks, with the caveat described below. I call it my optimistic scenario.

In short.
1)The regulators did not have the manpower to audit the huge financial sector at the time of crisis.
2)Instead of the impossible and wrong-headed approach of buying toxic assets, funds were used to buy time with temporary capitalization of banks.
3)The time bought has been used to gear up in manpower and technique to determine bank solvency.
4)Stress steps designed by the regulators and announced by Geitner are valid and will be used to to determine the level of solvency of banks.
5)Insolvent banks will be shut down and their assets redistributed.
6)Troubled banks will be operated or with extensive oversight by the regulators until they are determine solvent or insolvent.
7)Solvent banks will gain the the confidence to operate normally.

Arnold, despite all the politics, all the confusion, and all the difficulties, what is the likelihood that the above optimistic scenario is what is actually happening?

AJ writes:

Arnold, I'd like to hear your answer to Ed Hanson.

All of you above are also talking about solvency/insolvency like it's a known thing. In a liquidity crisis/panic, long term illiquid assets with thin resell markets collapse in price. The new policy (at least in law) since 2007 has been that banks must mark-to-market on these assets. This hugely exacerbates the swing in bank liquidity due to crisis versus the prior practice of letting these ride at cost or some other determination for awhile. I'm not saying to hide the value of these portfolios, but some of the gyration has been arbitrary in who and when gets marked to market.

Allen

AJ writes:

One approach would be to require banks hold x%, say 90% in assets which are publicly traded (T bills, bonds, REITs, etc. -- all with usual reserve requirement adjustments). This might force more of the grey obfuscation area of repackaging into publicly traded pools where the liquidity-price girations are less related to bank liquidity, and create more visibility. Mortgages would end up in REIT like entities rather than under a pile of impenetrable credit agreements, strips, insurance deals, and side-derivative bets. Tying these assets to market liquidity rather than a regulated banking system liquidity has pros and cons, but... on balance pros I think.


Jim Glass writes:

Seeking Alpha believes there are only two big US zombie banks, though they are the big ones, Bank of America and Citi. That's not as bad as many imagine (though it would have been unimaginably bad a year ago).

OTOH, Simon Johnson says the European banks are in much worse shape, and that much of the bailout of US banks and AIG effectively has been to support them.

Barkley Rosser writes:

I agree with Jim Glass.

Also, however, there is the problem that I do not believe there are enough funds in the FDIC reserve to handle a shutdown of both BOA and Citi. Need to get that shored up if this liquidate, liquidate, liquidate! strategy is to be pursued fully (especially as there may well be more biggies in the US besides those two; things seem to continue to deterioriate).

Bill Woolsey writes:

When the TARP bailout was first proposed, I was strongly opposed, but I thought that $700 billion might be needed to bail out FDIC.

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