Start from scratch (almost)

Commentary By Ron Beasley

Willem Buiter says rather than try to save the existing banks it would be cheaper just to start new ones from scratch.

Rather than wasting the $1.4 trillion of public funds it would take to restore (according to NYU economist Nouriel Roubini's estimate) the capitalization of the U.S. banking sector to its fall 2008 level, it would be better to use public money to capitalize new banks that don't suffer from an overhang of past bad investments and loans -- and to guarantee new borrowing or new loans and investment by these banks. This "good bank" model achieves this by identifying the systemically important banks that are kept afloat only by past, present and anticipated future public financial support ("bad banks") and taking their banking licenses away.

The "stress test" proposed by Mr. Geithner for major banks (assets in excess of $100 billion) could be used to gather the necessary information to identify the bad banks. New banks, capitalized by the government (possibly with private co-financing) would take the deposits of the bad banks and purchase the good assets from the bad banks. Future government support, through guarantees or other means, would be focused exclusively on new lending and new borrowing by the new good banks and those old banks that passed the stress test.

The legacy bad banks would not be allowed to make new investments or new loans and would simply manage the inherited stocks of assets in the interest of their owners. They sink or swim on their own. If they fail, their unsecured creditors can figure out what to do with the bad assets.

An intriguing idea to be sure and would at least to some extent avoid the scare words Nationalization and Socialism.  He goes into a bit more detail here:

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.

 

Comments

[Peter G.]

I don't think you could get away with this idea without a million lawsuits sprouting all over the land. Stripping out the good assets out of any bank and leaving the junk for the secured creditors would almost certainly never pass judicial review.