The Good Banks, the Bad Banks, and the Ugly Assets

Paul Romer says forget about trying to repair bad banks, let's create a few good banks:

Let's Start Brand New Banks, by Paul Romer, Commentary, WSJ: Everyone agrees that the United States urgently needs a few good banks. Turning bad banks into good banks is a difficult and risky way to get them. It's simpler and safer to start entirely new banks.

In this context, "good" means a bank with assets and liabilities that are easy to value using market prices. At a good bank, officers, regulators and investors can be confident about the value of the bank's capital.

The government has $350 billion in Troubled Asset Relief Program (TARP) funds that it can use to encourage new bank lending. If this money is directed to newly created good banks with pristine balance sheets, it could support $3.5 trillion in new lending with a modest 9-to-1 leverage. ...

If the TARP funds go to existing banks, much of them will end up stuck in financial institutions that are still bad after the transfer. We know from the previous round of TARP that giving more capital to bad banks generates very little net new lending. ... Without reliable market prices for the hard-to-value assets, any proposal for turning bad banks into good banks could lead to huge transfers of wealth between taxpayers and bank shareholders.

If the government lets new banks provide the new lending that the economy needs, it could return to clearly stated and familiar policies for bank regulation. ...

With a return to a clearly articulated and familiar pattern of bank regulation, investors from the private sector could invest in the banking sector without fear... [and] quickly create the new banks that the government backs. Over time, they can also buy the government's shares... The government's role is merely to act as a temporary bridge. ...

The brewing backlash against the existing players from the financial sector is almost certain to burn hotter as the recession wears on, and new election campaigns get underway. If the new administration ties its fate to the existing players, it could lose its room to maneuver on countercyclical policy and be put under political pressure to intervene in bank decisions in ever more intrusive ways.

Because they can and will borrow, new banks will be much more effective in leveraging TARP funds. They will undertake more total lending,... and do more to limit the depth of the recession. ...

Banks that are not viable, the ones with liabilities that substantially exceed their assets, will lobby vociferously against a return to historical patterns of bank regulation. They will say anything to postpone a looming FDIC takeover. The administration should not listen to threats and pleas from these doomed banks. ... New entrants could give us a few good banks. That, plus an FDIC that can do its job, is all we need.