By Viral V. Acharya

The G7 and Eurozone meetings have raised hopes of expedient recapitalization of several banking sectors with the use of public funds. Such recapitalization is rightly aimed at shoring up equity base of the highly leveraged banks whose capital is essentially eroded, and of better-capitalized banks whose equity base has suffered too due to a spillover from adverse news about the highly leveraged ones. In light of this much-needed response to the global financial crisis, it is important to remember that following the first round of recapitalizations, regulators should and will look for ways to “clean up” the system. To this end, well-capitalized banks and financial institutions need to be given incentives to acquire weak banks sooner rather than later.

Why clean up the system? Partial or full nationalization is a temporary measure to put the financial system on oxygen, but ultimately its arteries must be unclogged. The presence of “lemons” - troubled banks and their assets - is destroying confidence between banks and of investors in banks. These problems must be resolved promptly, though not as abruptly as was attempted with Lehman Brothers. Their resolution will leave the financial system with well-capitalized banks and healthy assets. This will restore confidence levels, enable banks to raise sufficient private capital in near future, and kick-start the currently moribund markets for inter-bank lending and commercial paper.

There are at least two ways to do the clean up and they are not mutually exclusive. The first way, which I prefer, is to identify and sell troubled banks to healthier institutions. Acquirers will assume assets as well as liabilities in the process. Governments should support such sales with subsidized funding or insurance against losses from acquisitions up to some level, effectively guaranteeing some liabilities of troubled banks. The sale of Bear Stearns to JPMorgan in March is a good example of this method. The second way is to restructure troubled institutions piece-meal, selling their healthier assets to other institutions, collecting the ones for which there is no current interest into a “bad bank”, and resolving the bad bank over time. Both methods rest on the premise that regulators can identify troubled banks. This can be done on a first pass by examining capital, leverage and loan-to-deposit ratios and on a second pass through audits by bank supervisors.

Why the preference for bank sales? Government-assisted sales are a particularly attractive way of deploying public funds. They kill two birds at the same time - provide capital to the system and entrust the complex task of managing and liquidating troubled assets to healthier parts of the private sector. Such sales also have the right properties in terms of not rewarding those banks or managements that did poorly or refused to raise adequate capital in time. Whether such sales will be sufficient for the clean up depends on the state and willingness of healthy institutions but also on the moral suasion powers of regulators. On the one hand, healthy institutions stand to gain substantially from such acquisitions. On the other hand, they will try to extract their pound of flesh or procrastinate so as to make acquisitions as cheaply as possible. This is precisely why governments should offer some assistance for acquisitions. It gives healthy institutions incentives to move sooner.

The piece-meal approach to resolving troubled institutions has been employed in the past during the Savings and Loans crisis in the United States as well as during the East Asian crisis. In the current context though, this requires substantial clarity on how creditor recoveries will be distributed, especially given the complex, contingent and international nature of debt. As such, this will call for seamless cross-border coordination. Besides, selling illiquid assets requires appetite from investors with long-term horizon. Currently, there are few such private investors. Hence, the agencies set up to resolve the troubled assets would have to be around for a while. Substantial legal and administrative costs will follow.

Overall, government-assisted bank sales, wherever feasible, present a more efficient form of public-private partnership. If acquisitions by foreign players are entertained, there are more than a handful of well-capitalized players who can be encouraged to move. While across-the-board recapitalization with public funds gets at the immediate issue of inadequate bank capital, using public funds to resolve the lemons reduces the cost for healthy banks to issue private capital. Both are in the interest of taxpayers.

Viral V. Acharya is a professor of finance at the Stern School of Business, New York University. In the summer of 2008 he was appointed Senior Houblon-Normal Research Fellow at the Bank of England, conducting research on efficiency of the inter-bank lending markets

Tags: UK economy

October 13, 2008 4:29pm in Central banks, Credit squeeze, Eurozone | Comment