"Message to Regulators: Bank Fix Needed Quickly"

Tyler Cowen is pessimistic about about the near term future of the banking industry:

Message to Regulators: Bank Fix Needed Quickly, by Tyler Cowen, Economic View, NY Times: A new bank rescue plan may be more crucial right now than the fiscal stimulus package enacted last month. Yet we don’t seem capable of finding a clear path toward cleaning up our major financial institutions. ... It’s worth considering why this is likely to be so.

The need for action is clear enough. ... But there has been no easy and affordable way to proceed. Three basic approaches can be taken:

The Shovel Method: The first, essentially, is to shovel money to banks and thus restore them to profitability. There are many paths toward this end, not all of them transparent. ... But no matter how it’s done, funneling money has been criticized as unjust to taxpayers — and could cost trillions to restore solvency.

Moreover... If the government commits to making banks whole again, the banks may become a bottomless financial pit.

The Control Method: The second set of solutions involves taking control of insolvent banks, either by nationalizing them or declaring them bankrupt. In the past, the Federal Deposit Insurance Corporation has used the model of rapidly shuttering failed banks, and it has usually worked.

Many analysts cite Swedish bank nationalization ... because the Swedes later reprivatized these banks and resumed economic growth.

But Sweden nationalized only two banks. And the Swedish banks were much smaller and easier to run... It is quite possible that the reputation of a nationalized bank would be so impaired that it would incur even greater losses as its web of commercial dealings collapsed. These far-reaching commitments are a reason that the F.D.I.C. model of rapid shutdowns cannot be applied so easily here.

The most obvious problem with nationalization is the risk of contagion. If the government wipes out equity holders at some banks, why would investors want to put money into healthier but still marginal institutions? A small number of planned nationalizations could thus lead to a much larger number of undesired nationalizations.

On top of that, the government doesn’t have the expertise to run large bank holding companies like Citigroup. ... In the meantime, there would be increasing pressure to politicize lending decisions — for instance, by requiring loans to the ailing automobile industry...

The plight of the American International Group, the giant insurer, provides a cautionary tale. ... If the government cannot run that bailout very well, how can it run major banks and nurse them back to profitability? ...

It’s easy to call for “transparency” in a banking plan.. But transparency isn’t a simple concept... For instance, standards for bank solvency depend on whether the government applies a “mark to market” standard to bank assets. If the long-run value of a mortgage security exceeds what it would fetch on the open market today, what is the security’s “transparent value,” and which figure should the government use in deciding whether to shutter or nationalize a bank?

There is not always a clear line separating solvent and insolvent banks. In many cases, the government would simply be choosing which banks deserve to survive.

The Band-Aid Method: A third approach to reform is to try to muddle through, with fixes here and there. The hope is that banks return to solvency over a few years, as markets improve. The results, though, are likely to be a lot of limping along, continued extension of credit to weak and ineffective banks, and not much resolution.

But because we don’t have a few trillion dollars to spend on bank recapitalization — with or without nationalization — this may be the best that the American political system can do for now.

The outlook is bleak. Perhaps true and irrevocable insolvency will force the hand of the regulators to act more decisively. In the meantime, the banking system will be very hard to fix.

Tyler Cowen emphasized "The Control Method's" problems in his excerpts of his article Arnold Kling responds:

Tyler Cowen writes,

A newbank rescue plan may be more crucial right now than the fiscal stimulus package enacted last month. Yet we don't seem capable of finding a clear path toward cleaning up our major financial institutions.

...It is quite possible that the reputation of a nationalized bank would be so impaired that it would incur even greater losses as its web of commercial dealings collapsed. These far-reaching commitments are a reason that the F.D.I.C. model of rapid shutdowns cannot be applied so easily here.

Read the whole thing. Tyler thinks we may just have to muddle along, trying to use band-aids and tourniquets. I continue to prefer the approach I suggested from the beginning.

1. Close any bank that is clearly insolvent.
2. If a bank may be solvent but fails to meet rigorous capital standards, then put it under close supervision until the situation resolves. The bank is not allowed to make any new risky loans, but otherwise it can continue to operate. The bank can borrow from the government to cover short-term liquidity needs, but not to expand operations, pay dividends, or compensate executives in cash (it can award them stock or stock options).
3. Leave healthy banks free to operate.

The difference between (1) and (2) is that in (1) the shareholders are wiped out immediately, while in (2) the shareholders have some upside. The difference between (2) and (3) is that with (3) the managers can actively try to increase shareholder value. With (2), the bank is effectively on probation, with shareholders only able to earn a return if it becomes clear that the bank's toxic assets are not sufficiently bad to take it into insolvency.

Sometimes there's more than one path to the same destination, and I think that more than one of the proposals to fix the financial system that have been proposed have a reasonable chance of helping. There is, of course, an optimal policy response just as there is a shortest path to a destination (whether we know what it is or not), but that doesn't mean other policies cannot be effective enough to make any difference. If politics blocks the shortest path, and a slightly longer path is open, then let's take it - we need to get there as fast as we can.

Thus, I would like to see policymakers make a firm decision on what to do and do it. They should choose a proposal that has been thoroughly examined so we know what the strengths and weaknesses of the particular policy are likely to be, including the political ramifications, explain in simple terms how it is expected to work and why it is in the interests of taxpayers to proceed along these lines, and implement the policy quickly and confidently. Tyler's point is right, there is no perfect plan, especially when political considerations are in the mix, but there are acceptable options and we need to pursue one of them as soon as possible. Recently, there has been some movement toward a plan, but it still lacks the clarity and air of confidence behind it that is needed.

It may be difficult to shed now given how policy has been conducted to date, but mainly I would like to see an end to the waffling, unsure, bumbling, making it up as we go along image that policymakers trying to fix financial markets have projected to this point.