With the collapse of privately owned and lightly regulated financial intermediation in the North Atlantic region in full swing, the focus of attention has quite naturally switched from the central banks to the Treasuries/ministries of finance. Central banks can and should provide liquidity on demand – after all, they can produce it for free. Central banks should not be asked to provide capital to insolvent banks, even if they could do so without endangering their price stability mandates. Central banks should be automatically and immediately indemnified by the Treasury for any losses suffered through the acceptance of risky collateral, through unsecured lending to private counterparties or through the outright purchase of risky private securities. Subsidies should be explicit and on the books and budget of the Treasury rather than buried in quasi-fiscal interventions by the central bank.
Central banks should, of course, continue to set their official policy rates to pursue their macroeconomic stability mandates: price stability for the Bank of England and the ECB and price stability and sustainable growth for the Fed. I believe that in both the UK and the euro area, real economic conditions have deteriorated so quickly and to such an extent that the balance of risks is now for the inflation target to be undershot rather than overshot over the horizon that the central bank can influence the inflation rate.
The likelihood of a systemically important financial institution becoming balance sheet-insolvent depends on two key factors. The first is the share of the financial institution’s net domestic-currency debt in its total net debt and the willingness of the monetary authorities to inflate away that debt. The second factor becomes relevant if either the financial institution has a significant net foreign currency liability, or if the monetary authorities are unwilling to generate the necessary inflation. This second factor is the size of the financial institution’s ‘solvency gap’ (at whatever rate of inflation the central bank generates) relative to the fiscal strength of the government that assumes responsibility for that institution. Even a very bad bank can survive if it is backed by a fiscal authority with sufficiently deep pockets. A moderately back bank may fail if the fiscal authority backing it does not have the capacity to make a sufficiently large resource transfer to it.
Before it was proposed, the Paulson plan (or rather its substantive content – the TARP) was neither necessary nor sufficient for a solution to the US banking crisis (let alone the banking crisis outside the US). But once it had been proposed, the confusing dynamics of market confidence made it imperative that it be passed. Now that it has been passed, the US and the world at large have a short breathing space in which to prepare the measures necessary to achieve a lasting solution to the crisis.
The interbank markets, secured and unsecured are, respectively, moribund and dead. The reason banks don’t lend to each other in the interbank market is counterparty risk – fear of default of the party they are lending to. Unsecured interbank lending (for which Libor or Euribor are common price measures) has effectively vanished, even at the overnight maturity. Secured interbank lending only occurs against very high-grade collateral and mainly for short maturities. It is quite possible, indeed likely, that unsecured interbank lending will not return on any significant scale – ever. In that case, Libor and Euribor would have to be replaced as benchmarks for pricing other private lending, by secured interbank lending rates, such as the OIS rate.
When banks don’t lend to each other, they are also unlikely to lend to economic agents that matter intrinsically: households and non-financial corporations. This has been a problem for a while in the US and the UK as regards bank lending to households, to developers and to firms in the construction sector. It is now spreading rapidly, in the US, the UK and in the rest of Europe, to the non-financial sector as a whole, starting with SMEs, but not stopping there.
To get interbank lending going again, banks must have confidence in each other’s solvency and liquidity. How can we restore trust in these interbank relationships? There are a number of options.
- Nationalise the banks. When they have a common majority owner (the state), the state can simply instruct the banks to lend to each other. Problem solved. It may come to that in any case, but for those who are not ready for such measures, here are a couple more.
- Guarantee interbank lending. Here the Treasury guarantees interbank transactions, both secured and unsecured. This should be done against fees that ensure the Treasury an acceptable risk-adjusted rate of return on this activity.
- Have the central bank interpose itself as the universal counterparty for interbank transactions. This is effectively already the case in the overnight market in the UK and the euro area. When the Fed starts paying interest on reserves (commercial bank deposits with the Federal Reserve System), we will see the same phenomenon there. In the UK, for instance, banks hold large deposits overnight with the Bank of England at the standing deposit facility (which pays 100 basis points below Bank Rate (the official policy rate) )and borrow either by running down these overnight deposits or by borrowing overnight at the standing lending facility (at a rate 100 basis points above Bank Rate). The same phenomenon can be observed with banks in the euro area. That 200 basis points spread (between the standing deposit and standing lending facilities rates) is hefty, but banks prefer it to taking the counterparty risk of other banks, even overnight. Instead of commercial banks A and B lending directly to each other at longer maturities than overnight, bank A could lend to the Bank of England, and the Bank of England could then on-lend to bank B, more or less ‘on demand’. This would require the Bank of England to take a view of what the interbank rate ought to be at all the maturities where it acts as the universal counterparty of last resort – something it has been loath to do. It could do this either for unsecured transactions or for both secured and unsecured transactions. The spreads and other fees associated with this counterparty of last resort role would vary with the maturity of the loan, the quality of collateral, and the Bank of England’s assessment of the creditworthiness of the banks borrowing from it.
It is clear that, throughout the observable universe, most banks and many other highly leveraged financial institutions are deemed to large, too interconnected or too politically connected and sensitive to fail. Indeed, even financial corporations masquerading as units of non-financial corporations (GE and GM come to mind) may well fall into this category. One way or another, the tax payer is on the hook for the banks, the AIGs and GEs of this world.
I have a modest proposal for aligning executive compensation better with shareholder interest.
Each year, at the annual shareholders meeting of any listed company (not just in the financial sector), shareholders vote, as a series of line items, on last year’s and next year’s compensation for top management and top staff. A concrete implementation would be as follows:
- The total compensation package for each of the 10 top executives and for each of the 10 best-paid staff (where these categories don’t overlap) for the coming year. The individual compensation package package that is voted on includes all benefits, in cash or in kind, unconditional, or conditional/contingent that the executive/employee is entitled to in the coming year plus any changes in the total compensation package for subsequent years.
- An independently audited report on last year’s total compensation package for each of the of the 10 top executives and for each of the 10 best-paid staff (where these categories don’t overlap). This report should contain an independent estimate of the difference between each individual compensation package approved at the previous shareholders meeting and the compensation actually paid or accrued. That difference, positive or negative, would have to be added to or subtracted from the compensation package about to be approved for the coming year (this second set of line item votes could, of course, only be started in the second year of the new arrangement).
- The rest of the annual report can be accepted even if the individual compensation packages are not approved.
- If an individual compensation package is not approved, the total compensation for the executive/employee in question will be the total compensation of the head of state or head of government (whichever is lower) of the country in which the company is registered/incorporated.
Policy authorities in Europe are rushing to guarantee the creditors of the banking system. Retail deposit holders are effectively safe everywhere, whatever the letter of the deposit insurance laws and regulations. Wholesale deposit holders are not far behind. The Irish government now has guaranteed all owners of majority Irish-owned Irish banks’ debt.
This moral-hazard-race-to-the-bottom, a textbook example of dysfunctional beggar-thy-neighbour policy competiton, must end, as it creates the most awful incentives for future reckless lending and investment. The EU should focus on a common set of rules limiting government guarantees to retail investors only.
Mandatory debt-to-equity conversions for all holders of preferred stock, subordinated debt and all other forms of unsecured debt should be part of any scheme to save the institution and its retail savers. Unless the bond holders and other non-retail creditors get a serious haircut/pay a hefty charge in these bank rescue operations, the authorities will have achieved the worst possible combination of ex-post grotesque unfairness and ex-ante bad incentives for future financial misbehaviour.
On September 30, 2008, the Irish government announced that it had put a guarantee on the entire liability side – except for the equity – of the balance sheets of the six largest majority-Irish-owned banks. This includes all deposits (retail, commercial, institutional and interbank), covered bonds, senior debt and dated subordinated debt (lower tier II). The guarantee will cover all existing and new facilities issued from midnight on 29 September 2008, and will expire at midnight on 28 September 2010.
I would like to thank my colleague Nick Barr for drawing my attention to the following quote:
“With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets, cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s.”
(Former Chairman Alan Greenspan of the US Federal Reserve Bank – Fourth Annual Community Affairs Research Conference Washington, D.C. April 8, 2005).
All fundamentalism is blind and dangerous.
Grandson of TARP is still alive. It now looks as though the Emergency Economic Stabilization Act 2008, rejected by the House of Representatives, will be resurrected with the addition of an increase in the limit of the FDIC’s deposit insurance scheme from $100,000.00 to $250,000.00 per person per bank. The increase in the insured deposit limit is a bad idea. Anyone holding more than $100,000.00 in a single bank should be encouraged to monitor his/her investment regularly and to spread it around if doubts about the bank’s solvency arise. With the long list of new facilities created by the Fed and the Treasury for banks to liquify their illiquid assets (through outright sale or through their use as collateral), the systemic risks associated with a deposit run on a solvent bank (that is, a bank that would be able to meet its obligations if all its assets could be held to maturity) are much reduced. Deposit runs on insolvent banks should be welcomed.
But the moral hazard created by raising the deposit insurance limit from $100,000.00 to $250,000.00 is minor compared to the benefits of having a TARP-like illiquid asset dump in place. As far as I’m concerned, the Treasury could throw in a free toaster for every depositor, signed by Obama and McCain (the toaster, that is, not the depositor), who between them have done so much to scupper the original plan.