Uwe is exactly right as to how the new banks would be established operationally. First, a new good bank is created for each existing bank that is revealed (through the stress tests proposed by US Treasury Secretary TIm Geithner as part of his Financial Stability Plan for all banks with assets over $100 bn, or through some other financial forensic exercise) to be not viable without public financial support. The new good banks would be established as legal entitities and as FDIC-insured commercial banks. They would be capitalised using private and public money, with the state ensuring that the new entities are properly capitalised.
The new good bank (New Citi or New Bank of America, say) would get the deposits of the old bank and it would purchase any of the good assets of the old bank it is interested in. All the bad assets and the toxic (hard or impossible to value) assets would be left with the old bank. If the value of the deposits transferred to the good bank exceeded the value of the good assets it purchased from the old bank, the difference on the balance sheet of the new bank would be made up initially through the acquisition of Treasury bonds and bills. On the balance sheet of the old bank, the difference would be made up through a loan from the state. If the value of the deposits transferred to the good bank were less than the value of the good assets it purchased from the old bank, the difference on the balance sheet of the new bank would be made up initially through the a loan from the state. On the balance sheet of the old bank, the difference would be made up through the acquisition of Treasury bonds or bills.
The old bank would lose its banking license and it would not be allowed to invest in any new assets. The old bank bank would receive no further public financial support of any kind. Government financial support for the banking sector would be restricted to ensuring the new good banks are properly capitalised and guarantees for new lending and borrowing by the new good banks and by those old banks that passed the stress tests.
The bad old bank It would manage the remaining assets of the old bank in the interest of the shareholders of the old bank. Should the old bank fail, the appropriate insolvency protection regime and insolvency regime for the asset management fund that the old bank has now become will be involved. The unsecured creditors (including the holders of senior unsecured debt) would be ad risk. At the very least, some or all of their claims are likely to be converted into ordinary equity. As an old bad bank is no longer in the new lending business and engages in new funding only to maximise the returns from managing (down) the existing portfolio of assets, the old bad banks are of no greater systemic significance than any other asset managers.
Among the good assets I would have the new bank buy from the bad old bank would be as much of the franchises, branches, offices and other real estate and equipment as are necessary to perform the lending, deposit taking and other functions of a (narrow) bank. I would also hire many of the staff (all but the top management) of the old bank. As the old bad bank no longer has a banking license, will no longer hold or take deposits, and will not be allowed to invest in any new assets, it will require just a relatively small number of asset managers and funding specialists to manage its assets. The old or legacy bad bank would just require the expertise of fund managers managing a fund that is constrained not to invest in any new assets.
As far as the banking customers (depositors and borrowers) are concerned, they would at first only notice the change in the name on the door (from Citi to New Citi or from Bank of America to New Bank of America). The legacy bad old bank fund management team could rent some space in the basement of the new bank. The whole exercise could be implemented over a weekend.
The senior debt of many of the institutions that are likely to turn out to be bad banks is often held by institutional investors like pension funds and insurance companies. If and when the old bad banks default on that debt, the holders of the debt obviously get hurt. While that is regrettable, it is surely better that the burden of the losses incurred as a result of past bad lending and investment decisions fall on those who made these decisions rather than on the tax payer.
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ARTICLE 3:
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Slaughtering sacred cows: it's the turn of the unsecured creditors now
March 18, 2009
Why are the unsecured creditors of banks and quasi-banks like AIG deemed too precious to take a hit or a haircut since Lehman Brothers went down? From the point of view of fairness they ought to have their heads on the block. It was they who funded the excessive leverage and risk-taking of banks and shadow banks. From the point of view of minimizing moral hazard - incentives for future excessive risk taking - it is essential that they pay the price for their past bad lending and investment decisions. We are playing a repeated game. Reputation matters.
Three arguments for saving the unworthy hides of the unsecured creditors are commonly presented:
* Unless the unsecured creditors are made whole, there will be a systemic financial collapse, with dramatic adverse consequences for the real economy.
* If the unsecured creditors are forced to take a hit, no-one will ever lend to banks again or buy their debt.
* The ultimate 'beneficial owners' of these securities - notably pensioners drawing their pensions from pension funds heavily invested in unsecured bank debt and owners of insurance policies with insurance companies holding unsecured bank debt - would suffer a large decline in financial wealth and disposable income that would cause them to cut back sharply on consumption. The resulting decline in aggregate demand would deepen and prolong the recession.
I believe all three arguments to be hogwash.
Armageddon
As regards the first argument - financial Armageddon - it may have escaped people's notice that, with the exception of a few struggling survivors, the large border-crossing banks in the north-Atlantic region would be insolvent but for past, present and anticipated future government financial support. Insolvent financial institutions on opaque tax-payer underwritten life support should instead be put into administration; if they are systemically important, the desired results can be achieved through the special resolution regime (SRR) with prompt corrective action (PCA) that most countries in the region now have in place. A standard and desirable feature of such (proto-) insolvency procedures is the mandatory conversion of unsecured debt into equity and/or the write-down of (part of) the unsecured debt.
The financial market cardiac arrest that followed Lehman's demise was not evidence that unsecured creditors should be spared. Lehman's insolvency and liquidation was the correct outcome, but the process was badly mishandled.
First, following the decision of the Fed and US Treasury to arrange for and underwrite the take-over of Bear Stearns by JPMorgan Chase, the market had been lulled into believing (I certainly did), that the US government had underwritten the entire balance sheet of the internationally visible US banking sector. Creating that belief, allowing people to act on it for six months. and then to say 'well, actually, we did not mean that' would obviously rattle the nerves of many. Letting the unsecured creditors of other banks and non-bank financial institutions take a hit would not create the same surprise today, judging from the CDS rates for most banks and the default risk premia on bank bonds.
Second, there was no SRR for investment banks at the time of the Bear Stearns crisis. Nor was there at the time of Lehman's collapse, six months later. The only insolvency option was to put these institutions in Chapter 11 or Chapter 7. That problem no longer exists, because the category of free-standing investment bank to which Bearn Stearns and Lehman belonged no longer has any members. The last two surviving members, Goldman Sachs and Morgan Stanley, became bank holding companies, supervised by the Fed and with the SRR and PCA regime appropriate to such institutions, administered by the FDIC.
Third, even absent a SRR for investment banks, it is extraordinary that the SEC, the Fed and the US Treasury did not between them come up with a way to ring-fence the 'financial infrastructure services' provided by Lehman through its role as a custodial counterparty in tri-partite repos. Again, with all major banks now subject to an SRR with PCA, this issue ought not to arise again. I hope that for systemically important non-bank financial institutions, including insurance companies like AIG, there now also exists an SRR, which allows the government to take over the management of the company, with full powers to sell assets, spin off business units and ring-fence subsets of the assets and liabilities.
The Fed's and US Treasury's multi-stage bail-out of AIG provided a massive windfall to a particular class of unsecured creditors, owners of CDS written by AIG. About $58 bn was paid out by government-bailed AIG to banks headquartered outside the US. While not all of that money necessarily represents a loss to AIG or to the US tax payer, it is surprising, to say the least, to have official US concern for the well-being of unsecured creditors of US institutions extend to foreign creditors. An admirable manifestation of internationalism.
The global financial cardiac arrest that occurred in the second half of September 2008 (and which now has passed), was in my view due more to the sudden dawning of the realisation that most of the leading border-crossing banks headquartered in the north Atlantic region were insolvent (but for the tax payer's past, present and future favours), that occurred when AIG had to be rescued. The insurance that banks had bought against default on their bond investments, first from the monolines and then from AIG and similar shadow-banking sellers of shadow-insurance products, turned out to be pretty much worthless.
The fear that followed the markets' realisation that the banking sector faced an insolvency rather than a liquidity problem did not abate when Treasury Secretary Paulson presented his first TARP proposal to the Congress. This consisted of three A4 sheets, which said: "I want $750 bn. I want it now. I will use these funds for good works, but I cannot tell you what these will be. Don't ask any questions. And you cannot sue me." This political blunder convinced many that the Treasury Secretary was out of his depth. When the initial request was turned into a 300 page regular pork-laden Congressional document, the market breathed a sigh of relief. But when Congress then turned down this proposal at the first time of asking, the markets realised that the Congress was childish and irresponsible.
Cardiac arrest seems a reasonable response to this cumulation of bad and worse news. A repeat does not seem likely. Major negative surprises about the health of key financial institutions are unlikely, because health perceptions are already so pessimistic. And compared to the Bush administration, the new administration is unlikely to be as accident-prone in its interactions with the Congress.
Unsecured creditors' strike
As regards the second argument - if banks default on their unsecured debt, no-one will ever lend to them again - it ought to be unnecessary to point to the logical flaws and to the empirical evidence to the contrary. Unfortunately, I hear the argument sufficiently often, I feel it incumbent on me to debunk it here.
First, when a borrower defaults on his outstanding debt, his ability to take on new debt and to service it improves. The only reason not to rush in and offer him your shillings immediately is the possibility that the past default provides evidence that increases the perceived likelihood of a future default. If the default was a pure 'bad luck' default, it would not do so. If the default is evidence of (unexpected) bad management by the borrower, new credit is less likely to be forthcoming. If the default is perceived as 'discretionary', that is, a case of 'can pay but won't pay', credit is likely to be cut off.
Second, even sovereign debt defaulters have not suffered dramatically for their transgressions. Serial sovereign defaulters like Argentina tend to be back in the market after as little as three years. The Russian and Ukranian defaults of 1998 did not banish these countries to the Valley of the Financial Lepers for very long. Carmen Reinhard and Kenneth Rogoff have written two wonderful historical studies of sovereign defaults on external debt and on internal debt. I recommend both papers highly.
Even more relevant is the fact that, if the authorities adopt the good bank solution proposed by (among others) Paul Romer, Joseph Stiglitz, George Soros, Robert Hall and Susan Woodward and myself, it would be the legacy banks, stripped of their banking licenses and not engaging in any new lending or new investments, that would default on the unsecured debt. The new good bank (with just the (insured) deposits and the good assets of the original bank on its balance sheet in the version of the good bank model proposed by Hall and Woodward), could, until emotions and moods have settled, have its new unsecured debt guaranteed by the government. Rational would-be new unsecured creditors of the new good bank would in any case not be deterred by the bad experience of the old unsecured creditors of the bad bank. So there should be no problem attracting new unsecured creditors willing to lend to the banks.
Finally, a modicum of discouragement of new unsecured creditors is desirable. We don't want to return to the reckless unsecured lending to banks of the past - lending that was highly instrumental in bringing us the crisis. Greater lender caution and prudence and a higher interest rate on unsecured lending to banks will be a positive and desirable feature of the landscape banks will have to operate in during the years to come.
Pensioners won't spend
Default on unsecured debt, whether it takes the form of a write-down or write-off or (partial) conversion into equity will, through the pension funds and insurance companies holding these instruments, affect the consumption decisions of pensioners who find themselves with seriously diminished pensions and insurance policy holders whose policies have diminished in value.
I agree that this is what will happen. But what happens if instead the government bails out the unsecured creditors and makes the pensioners and insurance policy holders whole? The losses are still there and the government has to pay for them.
Consider the case where the government funds the secured creditor bail-out by raising taxes immediately. Unless there are important distributional asymmetries in the incidence of the tax increase under the bail-out scenario and the incidence of the losses suffered by the pensioners and insurance policy holders under the no bail-out scenario, the negative effects on demand should be about the same. If the unsecured creditor bail-out is financed by cutting public spending on goods and services immediately, the negative effect on demand is likely to be greater under the bail-out scenario than under the no-bail out scenario.
If the government borrows to fund the unsecured creditor bail-out, the bail out will be less contractionary than the no-bail out scenario, unless there is Ricardian equivalence (debt neutrality) - something I consider empirically untenable - or there is financial crowding out through an adverse asset market response to larger deficits. This could happen if the government has limited 'fiscal spare capacity' - its ability to commit itself credibly to future tax increases or public spending cuts is limited. In that case the government could still achieve a more expansionary effect from the bail-out scenario than from the no-bail-out scenario, if it were to monetise the debt incurred as a result of the bail-out. Of course, this monetisation could only be temporary if inflation is to be avoided when the economy returns to full employment.
More importantly, the government could prevent a decline in aggregate demand under the no-bail out scenario by a conventional Keynesian demand stimulus (tax cut or public spending increase), financed either by borrowing or by printing money. Even a balanced-budget increase in public expenditure on goods and services would be expansionary given a strict Keynesian multiplier.
So the third argument, that not bailing out the unsecured creditors would lead to a contraction of aggregate demand, may well be true but does not represent an argument for bailing out the unsecured creditors. The superior aggregate demand effects from bailing out the unsecured creditors by borrowing or printing money, compared to a policy of not bailing out the unsecured creditors exists only if the policy of not bailing out the unsecured creditors is accompanied by the government not doing anything on the fiscal side. The same demand-supporting effect achieved with the deficit-financed bail-out, can be achieved equally well by not bailing out the unsecured creditors and implementing a deficit-financed expansionary fiscal measure.
I conclude there are no valid arguments against forcing the unsecured creditors of bank and other financial institutions to sink or swim on their own, without any financial support from the state. Fairness considerations and moral hazard certainly support putting the unsecured creditors at risk. They made their bed; now they should lie in it
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ARTICLE 4:
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Don't touch the unsecured creditors! Clobber the tax payer instead.
March 13, 2009
Good Bank vs Bad Bank
The Good Bank solution differs significantly from the Bad Bank solution as regards its distributional implications, its medium-term and long-term incentive effects and its immediate financial stability impact.
Under the Bad Bank approach, the authorities either purchase toxic assets from the banks that made the toxic investments/loans, or they guarantee (insure) these toxic assets. Toxic assets are assets whose fair value cannot be determined with any degree of accuracy. Clean assets are assets whose fair value can easily be determined. Clean assets can be good assets (assets whose fair value equals their notional or face value) or bad assets (assets whose fair value is below their notional or face value). When the authorities acquire the toxic assets outright, they establish a legal entity to manage these assets - the Bad Bank. The publicly-owned Bad Bank either sells these toxic assets as and when they cease to be toxic and a liquid market for them re-emerges, or holds them to maturity.
Under the Bad Bank approach, the legacy banks, either sans the toxic assets or with the toxic assets guaranteed by the state, live to fight another day. The presumption is that the state overpays for the toxic assets. The price it pays is certainly greater than the immediate liquidation value of the assets by their owners. It is also likely to exceed the present discounted value of the future cash flows of the assets, or their hold-to-maturity value. Similarly, the cost of any guarantees provided by the state in the case where the toxic assets continue to be held by the banks, is likely to be less than the fair value of these guarantees.
The rationalisation for the creation of Bad Banks and for toxic asset purchases by the state that was part of the original TARP proposal - it would serve as a price discovery mechanism for potentially socially useful financial instruments that had temporarily become illiquid - is no longer credible. Most of the toxic assets ought never to have been created and, with a bit of luck, will never be seen again. So the fundamental rationale for the creation of Bad Banks and for toxic asset purchases by the state is the provision of a subsidy to the banks that made the toxic loans and investments. These beneficiaries include the top management and board of these banks, the shareholders and the unsecured and non-guaranteed creditors.
The subsidies for the legacy banks inherent in the purchase by the state of the toxic assets and/or in the guarantees provided by the state for these toxic assets are further boosted by the myriad modalities of further official financial support for these banks. These can be additional capital injections, guarantees for new borrowing or guarantees for new loans and investments by the banks.
Under the Good Bank approach, the state creates a new bank, the Good Bank, which gets the deposits and the clean assets of the old banks. The old bank gets compensation equal to the difference between the (known) value of the clean assets it loses and the value of the deposits it gives up. The state may also inject additional public capital into the Good Bank, or it may invite in additional private capital. Government financial support is given only to new lending, new investment and new funding by the Good Bank. The legacy (ex-)bank has its banking license taken away and simply manages the existing stock of toxic assets. The legacy (ex-)bank does not get any further government support.
The Hall-Woodward-Bulow good bank solution
A particularly neat example of the Good Bank solution has been proposed by Robert E. Hall of Standford University and Susan Woodward of Sand Hill Econometrics. It can be found on the Vox website. They attribute the key idea to Jeremy Bulow. In what follows I merely adapt their numerical Citicorp example to the RBS Group.
The data for the Table below come from the Annual Report & Accounts 2008 of RBS. I am doing the exercise for the whole RBS Group. As it is unlikely that home country governments would be willing (or even able) to support the foreign subsidiaries of their banks, it might have been more appropriate just to consider the UK high-street banking units of the RBS Group. I leave that as an exercise for the reader.
Total equity of the RBS Group at the end of 2008 is reported on the balance sheet as just over £80bn. Market capitalisation is around £ 8bn. I therefore subtract £72 bn from the £2,402 total assets reported for the end of 2008, which leaves adjusted total assets at £2,330 bn. The tax payer has already put £45 bn into RBS. In addition, RBS has placed £325 bn of toxic assets in the government's Asset Protection Scheme.
This means that RBS is a dead bank walking, a zombie bank, with its market capitalisation much less than past and present government financial support, let alone past present and anticipated future government financial support, which would also be reflected in today's market capitalisation. I could have done the same type of exercise for Lloyds Banking Group, for Citicorp, for Bank of America or for UBS and many other zombie border-crossing banks.
Good Bank -Bad Bank
Deconstruction of RBS Group end-2008 Balance Sheet
(following the Hall-Woodward-Bulow approach) (£ bn)
RBS Good Bank Bad Bank
Assets
Clean assets
(good & bad) 1,o12 1,012 -
Toxic assets 325 - 325
Derivatives 993 - 993
Equity in other bank - - 114
Total assets 2,330 1,012 1,432
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Liabilities
Deposits 899 899 -
Debt securities &
other non-deposit 452 - 452
liabilities
Derivatives 971 - 971
Total liabilities 2,322 899 1,424
Equity 8 114 8
Total liabilities
& equity 2,330 1,013 1,432
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Capital ratio 0.34% 11.25% 0.56%
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On the asset side of RBS group are clean assets (good and bad, but with known fair values) and toxic assets (assets with unknown fair values and derivatives. On the liability side, I distinguish deposits, debt securities and other non-deposit liabilities, and derivatives. In the US, the derivatives on both the asset and liability sides of the balance sheet would have been netted, which would have reduced the size of the balance sheet by almost one trillion pounds.
I assume that the £325 bn worth of toxic asset insurance offered by the authorities to RBS equals the stock of toxic assets on its balance sheet. This leaves RBS with just over £ 1 trillion worth of clean assets (and the derivatives, just under £1 trillion). 'Deposits' is shorthand for guaranteed or secured creditors. The £899 bn worth of deposits on the RBS balance sheet is, however, larger than what is formally covered by UK deposit insurance (or by the applicable deposit insurance schemes of the foreign subsidiaries). Debt securities and other non-deposit liabilities are claims on RBS by unsecured and non-guaranteed creditors. They include all unsecured debt, including subordinated debt, other junior debt and senior debt. RBS had £452 bn of this unsecured and non-guaranteed debt (plus of course some non-guaranteed and unsecured liabilities included in 'deposits'). Then there is just under £1 trillion worth of derivatives on the liability side of the balance sheet.
Equity - market capitalisation - is a mere £ 8 billion, giving a capital ratio (equity as a percentage of assets) of 0.34%. Even with all the government support it has received, RBS group is effectively worth nothing.
The Hall-Woodward-Bulow Good Bank - Bad Bank deconstruction of the RBS balance sheet requires one key condition to hold: the value of the clean assets of RBS has to exceed that of its deposit liabilities. This will be more likely the larger the amount of non-deposit funding RBS engages in.
We split RBS into a Good Bank and a Bad Bank by giving the deposits and the clean assets of RBS to the Good Bank, leaving everything else with the Bad Bank, and giving the Bad Bank all the equity in the Good Bank. (The derivatives on both sides of the balance sheet could be given to the Good Bank instead of to the Bad Bank, assuming they are clean). Since the value of the clean assets (£1,012 bn) exceeds that of the deposits (£ 899 bn), the good bank has equity of £114 bn (mind the rounding errors!). Its capital ratio is a healthy 11.25%. If I had used a more restrictive definition of 'deposits', the capital ratio could easily have been over 20% or even 30%.
The Bad Bank keeps the toxic assets and derivatives of RBS. It also has the equity in the Good Bank as an asset on its balance sheet. On the liability side it has just the unsecured and non-guaranteed debt securities and other non-deposit liabilities. Its equity is, of course, the same as that of RBS: £8 bn. Its capital ratio will therefore be higher than that of RBS, because the balance sheet of the Bad Bank is smaller. Neither the equity owners of the Bad Bank nor the unsecured and non-guaranteed creditors of the Bad Bank are worse off than, respectively, the equity owners of RBS and the unsecured and non-guaranteed creditors of RBS.
To achieve the deconstruction/decomposition of RBS into a Good Bank and a Bad Bank according to the Hall-Woodward-Bulow principles would require that RBS be put into temporary administration. The new Special Resolution Regime (SRR) introduced for the UK in February 2009 provides the ideal legal setting for this. It should not take long, a weekend at most. Basically, the Bad Bank just becomes a financial portfolio of toxic assets and derivatives, plus its stake in the Good Bank. It would not be allowed to invest in any new assets or to engage in any banking activities. It would manage the existing asset portfolio down and would cease to exist once the last asset has been sold or has matured. Among the clean assets the Good Bank buys would be the buildings, equipment etc. necessary for conducting the banking operations of the Good Bank.
If the UK government had not been daft enough to guarantee the £325bn worth of toxic assets on the balance sheet of the Bad Bank, there can be little doubt that the Bad Bank I have just constructed would have failed soon after coming out of the SRR. The Bad Bank, which is just a fund restricted not to invest in new assets, would be put into administration. The shareholders would be wiped out (more than 70 percent of RBS is now government-owned), and the unsecured and non-guaranteed creditors would determine what to do with the Bad Bank and its assets. Most likely there would be a significant debt-to-equity conversion and/or a large write-down of the debt.
The government would focus its financial support on the Good Bank, either by providing it with additional capital or by guaranteeing new lending and/or new borrowing by the Good Bank. Private capital could be attracted into the Good Bank too.
Distributional differences between the Good Bank and the Bad Bank solution
The Good Bank solution favours the tax payer. The Bad Bank solution favours the unsecured and non-guaranteed creditors of the zombie banks. 'Tax payer' includes those beneficiaries of public spending programmes that may have to be cut to meet the fiscal cost of purchasing or guaranteeing the toxic assets under the Bad Bank solution. It also includes those who lose as a result of future inflation or sovereign default, should either of these two solutions to dealing with the public debt created as a result of the Bad Bank solution eventually be adopted.
The Bad Bank solution also favours the shareholders of the zombie banks, but in the case of RBS, this is mainly the government and therefore the taxpayers. The amount of shareholder equity involved in the zombie banks is, in any case, negligible compared to the exposure of the unsecured and non-guaranteed creditors. The Bad Bank solution also saves the jobs and perks of the top management and the boards of the zombie banks - often the very people responsible for turning a once-healthy bank into a zombie bank.
There can be no doubt that, from a distributional fairness perspective, the Good Bank solution beats the Bad Bank solution hands down.
Incentive effects of the Good Bank and the Bad Bank Solution.
The Bad Bank solution creates moral hazard, because it rewards past reckless investment and lending. It also represents an inefficient use of public funds in stimulating new lending by the banks. To stimulate new lending, a subsidy to or guarantee of new lending is more cost efficient than the ex-post insurance of losses that have already been made on old lending, even though their true magnitude is not yet known. The Good Bank solution leaves the toxic waste with those who invested in it and with those who funded these activities, freeing government funds for reducing the marginal cost of new lending or increasing the expected return to new lending.
Both as regards moral hazard (incentives for excessive future risk taking) and as regards the efficient use of government funds ('new lending bang per buck'), the Good Bank solution beats the Bad Bank solution hands down.
Financial stability implications of the Good Bank and Bad Bank solutions: saving banking, without saving bankers or the existing banks
The holders of bank debt, with the possible exception of perpetual subordinated debt (which counts as tier one capital in some countries), have become the sacred cows of this financial crisis. Regulators, central bankers and Treasury ministers are quite willing to see shareholders wiped out. After the demise of WAMU and Lehman Brothers, however, the unsecured creditors have become inviolable. Somehow, those in charge of macro-prudential stability, notably the Fed, have bought into the notion that if there is either a further default on bank debt, or a restructuring involving a significant debt-to-equity conversion, or a signficant write-down of the claims of bank bond holders, this will be the end of the world.
I just don't buy it. Fortunately, I am not the only one. Luigi Zingales, the Robert C. McCormack Professor of Entrepreneurship and Finance at the Chicago Business School, has been advocating the case for mandatory debt-into-equity conversions, debt forgiveness and other up-tempo Chapter 11- style financialestructuring of banks and other defunct behemoths like GM, since the first days of the crisis (see e.g. (1) and his book Saving Capitalism from the Capitalists, co-authored with Raghuram Rajan). Robert Hall and Susan Woodward also feel no need to pay any special attention to or lavish any public funds on the toxic assets, their owners and those who funded them (the unsecured and non-guaranteed creditors) once the Good Bank has been established and sent on its way.
Part of the reason there appears to be this widespread belief that you have to guarantee all bank liabilities is that this is what the Swedish authorities did during their 1991-1993 banking crisis (see e.g. Lans Jonung's paper "The Swedish model for resolving the banking crisis of 1991-93. Seven reasons why it was successful" . First, Jonung lists seven criteria for 'successful' resolution of a banking crisis. The paper does not demonstrate that this septet constitutes a set of necessary and sufficient conditions for success - if indeed the Swedish approach is deemed to have been a success. Second, success is in the eyes of the beholder. The Swedish banking system has been hard hit again in the current crisis by its overexposure (30 percent of annual GDP) to risky investments in Central and Eastern Europe, including the Baltics and Ukraine.
Every financial boom/bubble has been characterised by rising and ultimately excessive banking sector leverage, that is, by excessive lending to banks. If all the unsecured creditors of the banking system were made whole in the previous systemic crisis, it is not really surprising that the banks, and their creditors, are back for more.
In a more systematic study of the use of blanket guarantees of bank liabilitiesLuc Laeven and Fabian Valencia find the following:
"Using a sample of 42 episodes of banking crises, this paper finds that blanket guarantees are successful in reducing liquidity pressures on banks arising from deposit withdrawals. However, banks' foreign liabilities appear virtually irresponsive to blanket guarantees. Furthermore, guarantees tend to be fiscally costly, though this positive association arises in large part because guarantees tend to be employed in conjunction with extensive liquidity support and when crises are severe."
The proposition that the consequences of inflicting losses on holders of bank debt are awful beyond our wildest imagining is voiced incessantly and loudly by bankers and by those long bank debt, especially insurance companies and pension funds. And a vigorous campaign is underway to extend the no-default presumption to the debt of pseudo-banks like AIG.
The most over-the-top, ludicrous piece of attempted scare mongering about the systemic risk implications of default by any institution I have ever read is the internal memorandum "AIG: Is the Risk Systemic", of 26 February 2009, which is now all over the internet. Just one small sample: "The failure of AIG would cause turmoil in the U.S. economy and global markets , and have multiple and potentially catastrophic unforeseen consequences".
I would have thought that, on the contrary, markets have discounted the likelihood of default by many of the major border-crossing banks, and by AIG, pretty comprehensively by now. After the US authorities bailed out Bear Stearns in March 2008, letting Lehman go belly-up in September 2008 was a bad surprise. Even then, I don't accept the interpretation that it was Lehman's filing for bankruptcy protection that triggered the cardiac arrest in global financial markets in the second half of September 2008. Instead the financial sector convulsions of the last quarter of 2008 were caused by the realisation that (1) most of the US and European border-crossing banks were insolvent without government financial support, that (2) the rot extended to the shadow banking sector (AIG), and that (3) the US authorities (Treasury, Fed, SEC) were not on top of the issue and that Congress was bound to act irresponsibly.
But even if it had been Lehman that triggered the financial upheaval, that was then. This is now. Banks, counterparties, investors and policy makers have had 6 months to adjust to the new reality and prepare for the eventuality of default on zombie bank debt and even on AIG debt. The bonds of large zombie banks trade at spreads over government yields comparable to those of automobile manufacturers (600 - 650 basis points). Their CDS spreads put many of these banks well into the default danger zone. Their stock market valuations are consistent with those of institutions not a mile away from insolvency and default.
The fact that zombie banks or AIG are self-serving when they plead systemic risk as an argument for further government hand-outs does not mean that they are wrong. It does lead one to verify more carefully the logic of their arguments and the quality of the empirical evidence offered in support. Let me just consider the argument that the main investors in bank debt (and AIG debt) - pension funds and insurance companies - are too vulnerable and too systemically important to permit the banks (or AIG) to fail.
Pension funds don't go broke with adverse effects on systemic stability. If they are funded, defined-contribution funds, a reduction in their asset value means that pensioners will get lower pensions. If they are defined-benefit schemes (including 'final salary schemes'), the risk of investment surprises is shared by the sponsors and the beneficiaries. When the Dutch pension fund ABP took a big hit last year, my parents did not get any indexation of their pension benefit. In past years, pension benefits had tracked earnings inflation, and occasionally price inflation. Should coverage ratios decline enough, even nominal cuts in pension benefits can be implemented. This may cause hardship, but not financial instability. No reason to favour the pensioners over the tax payers.
As regards insurance companies, I doubt whether "Insurance is the oxygen of the free enteprise system", as AIG would like us to believe. Certainly insurance companies like AIG are not the only suppliers of oxygen. Insurance is a regulated industry. Orderly restructuring following administration and insolvency need not interfere with the provision of any of the essential infrastructure services required for the proper functioning of a market economy.
Regulators, especially but not just in the US, have bought the 'don't touch the unsecured creditors' argument. The Fed especially appears to have swallowed it hook, line and sinker. This cognitive regulatory capture has turned the Fed, with the enthusiastic support of the FDIC and the US Treasury, into the most powerful moral hazard propagation machine ever.
If a bank or an insurance company like AIG is at risk of failing but is truly too big or too interconnected to fail (rather than merely too politically connected to fail), and if a Good Bank solution is not feasible, then the institution in question should immediately be taken into public ownership or put into a special resolution regime, if one is available. From public ownership it can be put into administration. Once in administration or under a Special Resolution Regime, it can be restructured decisively through a mandatory debt-to-equity conversion or debt write-down. There is no case for sparing the unsecured creditors.
