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Sunday, May 03, 2009

"Troubled Banks Must be Allowed a Way to Fail"

Kansas City Fed president Thomas Hoenig has a plan for allowing large and systemically important banks to fail. If we prevent financial institutions from becoming so large and systemically important in the first place, the plans below wouldn't be needed. But if we going to allow such institutions to exist - not my first choice but for now we have what we have - then this is a reasonable approach to take. One difference I have, though, is that I think that stronger form of guarantee for depositors, a key component of the Swedish plan, is needed. That changes the equity calculations when you look solely at the flow of money to depositors, and the politics of that aren't great, but the improved overall outcome can more than compensate for the cost of the government guarantees:

Troubled banks must be allowed a way to fail, by Thomas Hoenig, Commentary, Financial Times: When the financial crisis began ... in 2007, US policymakers reacted quickly out of fear that ... events would lead to a global economic collapse. In my view, the policy response ... has been ad hoc, resulting in inequitable outcomes among firms, creditors, and investors. Despite taking a number of actions..., uncertainty continues and markets remain stressed.

I believe there is an alternative method for addressing this crisis...: the implementation of a systematic plan to resolve large, problem financial institutions. ... Boiled down..., the plan would require those firms seeking government assistance to make the taxpayer senior to all shareholders, with the government determining the circumstances for managers and directors. ...

Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is ... re-privatised as soon as is feasible. ...

This plan has ... management and shareholders bear the costs for their actions before taxpayer funds are committed. This process also is equitable across all firms; is similar to what is currently done with smaller banks; and provides a definitive process that should reduce market uncertainty. ...

In contrast..., the current policy raises a host of issues:

● Certain companies have not been allowed to fail and, as a result, the moral hazard problem has substantially worsened. ...

● So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable..., they have actually been subsidised in becoming more economically and politically powerful.

The US government has poured billions of dollars into these firms without a defined resolution process... The longer resolution is postponed, the greater the losses and the larger the debt burden.

● ...[T]he Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role. This ... may compromise ... independence ... and make it more difficult to contain inflation in the years to come.

● ...We have entrenched these even larger, systemically important, “too big to fail” institutions into the economic system, assuring that past mistakes will be repeated.

Certainly, the approach I suggest for resolving these large firms also is not without substantial cost, but it looks to both the short and long run. ... While I agree that central banks must sometimes take actions affecting the short run, they must keep the long run in focus or risk failing their mission.

The fact that Citibank can negotiate the outcome of the stress tests is, I think, pretty good evidence that banks have become too big and too politically powerful for our collective good. (See here too.)

    Posted by on Sunday, May 3, 2009 at 01:49 PM in Economics, Financial System, Market Failure, Policy | Permalink  TrackBack (0)  Comments (14)

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