Good Bank/New Bank vs. Bad Bank: a rare example of a no-brainer

The truth of a proposition is independent of how many people believe it to be correct. The merits of a proposal are likewise not enhanced by the number of people supporting it or making similar proposals.  Still, humans, like other pack animals, thrive on companionship. It is therefore comforting that the logic behind my proposal (January 29, 2009) for one or more new ‘good banks’ to be established, capitalised with public money and with additional financial support from the state for new lending and new funding, while the toxic assets of the old banks are left with the owners and creditors of the ‘legacy banks’, is being echoed in proposals from Joseph Stiglitz (February 2, 2009), George Soros (February 4, 2009) and Paul Romer (February 6, 2009), to name but a few.  I claim no authorship or originality for the ‘good bank’ proposal.  The idea is obvious and no doubt was floating around the blogosphere and elsewhere as soon as the magnitude of the insolvency disaster in the banking sector became apparent.

The various proposals differ in detail.  Romer’s proposal is essentially the same as my own.  Stiglitz argues, according to the British Daily Telegraph that “the government should allow every distressed bank to go bankrupt and set up a fresh banking system under temporary state control rather than cripple the country by propping up a corrupt edifice”.

Soros proposes not to remove the toxic assets from the banks’ balance sheets (which would require them to be valued, which is not possible) but instead put them into a “side pocket”. The necessary amount of capital – equity and unsecured debentures – would be sequestered in the side pocket. Soros’ ‘side pocket’ is effectively the same as my ‘legacy bad banks’. Soros notes that about $1.5 trillion is likely to be required to recapitalise the existing banks properly.  This money could be leveraged a lot more effectively if most of it were injected into the new good banks, unencumbered with the toxic waste of the existing banks.

Under the Soros proposal, some additional capital might have to be injected into the ‘side pockets’, presumably by the state.  Under my new good banks proposal, the new good banks would take on the (guaranteed or insured) deposits of the legacy bad banks (which would lose their banking licenses) and would buy the good assets of the legacy banks.  Should deposits exceed good assets, the state would have to make up the difference initially with government debt on the balance sheet of the new good banks.  Should deposits be less than good assets, the new good banks would be able to borrow from the sovereign to finance the acquisition of the good assets from the legacy bad banks.  This would cleanse bank balance sheets and transform them into good banks but leave them undercapitalized. Soros suggests that $1 trillion of the estimated $1.5 trillion required to recapitalise the existing banking system should be directed to the cleansed banks. Soros believes or hopes that some of the money required to capitalise the new, cleansed banks could come from the private sector.  Under my proposal, and that of Stiglitz, the state would initially capitalise the new banks on its own.

A common logic
The logic is simple.  Many (probably most, possibly all but a handful) high-profile, large border-crossing universal banks in the north Atlantic region are dead banks walking – zombie banks kept from formal insolvency only through past, present and anticipated future injections of public money.  They have indeterminate but possibly large remaining stocks of toxic – hard or impossible to value – assets on their balance sheets which they cannot or will not come clean on.

This overhang of toxic assets acts like a tax on new lending.  Banks are required, by regulators or by market pressures, to hoard capital and liquidity rather than engaging in new lending to the real economy.  The public financial support offered in the form of capital injections (in the US mainly through preference shares and other non-voting equity), guarantees for assets and for  liabilities (old and new), insurance of toxic assets (as provided to Citigroup by the US sovereign) and possibly in the future through direct purchases by the state of  toxic assets (using TARP money in the US) and the creation of one or more publicly owned ‘bad banks’ has been a complete failure.

The  bad bank proposals the Obama administration and other governments are considering are non-starters, for the simple reason that they require the valuation of assets whose true value (even on a hold-to-maturity basis) can only be guessed at.  The good bank proposal only requires the valuation of those assets on the balance sheets of the existing banks that are easy to value: transparently valued assets.  The toxic stuff is left on the balance sheet of the existing banks, which become the legacy bad banks.

Offering to pay enough to the existing owners of the toxic assets to induce these owners to sell them would require paying over the odds.  That might not leave enough fiscal resources to support the new lending activities that are so urgently needed.  It would also be an unfair and moral-hazard-maximising bail out of the existing owners and creditors of the banks.  Nationalising the dodgy banks (or even the entire cross-border universal banking sector) would only solve the valuation problem of the new owner (the state) after nationalisation.  The toxic assets could be transferred into a bad bank at any valuation, including zero.  The owner of the bad bank and of the cleansed bank are the same.  Nationalising the dodgy banks would not solve the problem of how much to pay for the banks, however, because that would depend in part on the valuation of the toxic assets.  The good bank proposal creates new, publicly owned banks which only purchase good assets from the legacy bank.  There is no valuation issue involving toxic assets for the tax payer.

Crisis fighting, moral hazard and fairness
The existing packages of support measures in the US, the UK and elsewhere have failed to get lending to the real economy going again.  In the US especially, but also to some extent in the UK, It has been a shameful boondoggle for the banks that are at the heart of the financial mess – bank CEOs and other top managers, bank shareholders, holders of unsecured bank bank debt (subordinated, junior and senior) and other creditors.

The US, the UK and several other continental European countries are at risk of emulating Ireland, where the government first guaranteed all the liabilities of the banks (other than equity) and only after that began to nationalise the banks.  This leaves the Irish government today in the not too enviable position of having to choose between sovereign default and bleeding the tax payer and the beneficiaries of normal public spending to make whole all the creditors of the banks.

Bailing out the holders of existing bank debt and other bank creditors would be outrageously unfair: they did the lending and made the investments, they should eat the losses.  In addition, many of the creditors are likely to be much better off, even after they write down/off their claims on the banks, than most of the tax payers and public expenditure beneficiaries that pay for the bail out.  Bailing out the existing creditors would also create dreadful incentives for excessive future risk-taking by banks.

Especially in the US, the disdain for moral hazard displayed since the beginning of the crisis by regulators and by the fiscal and monetary authorities has been shocking.  It has been justified with the claim that you cannot afford to worry about medium- and long-term incentives for appropriate risk taking when your  house is on fire.  That argument is logically flawed.

Two things are systemically important.  The first is to restore the operation of key financial markets that have become illiquid.  The Fed is doing a reasonable job in that regard.  The second is to restore bank lending to the real economy.   Neither objective requires that the existing banks be saved, let alone that their existing shareholders and creditors receive any financial support from the state.  We can save banking without saving the banks or the bankers.  The ‘good bank’ proposal demonstrates how to do this.

Regulators, central bankers and policymakers should be pursuing three key objectives.  The first is to get lending by the banks to the real economy, especially to the non-financial enterprise sector, going again. The second is to minimize moral hazard by creating the right incentives for future risk taking by banks, their creditors and their customers, by ensuring that the losses incurred by the failed banking system are born first and foremost by those who invested in the banks in any capacity.  For reasons that are partly sensible (protecting small unsophisticated savers from financial ruin and forestalling inefficient attempts by financial illiterates to monitor complex financial institutions) and partly populist pandering, most retail deposits have ended up insured or guaranteed by the state (often at least in part ex-post).  Moral hazard should be stopped, however, beyond the magic circle the state has drawn around retail depositors.  The third objective is to pursue justice in burden sharing.

The legacy bad banks would, under their existing ownership and with whatever balance sheet they end up with after shedding their insured/guaranteed deposits and after selling their good, easily valued assets, have as their sole activity the management of their existing assets.  No new investments would be undertaken, no new loans made and no other new exposures incurred.  Their liabilities and other funding decisions would be managed in the interests of the existing shareholders.  No doubt many of them would fold.  Chapter 11 or Chapter 7 would be ready and waiting for them.

By focusing scarce fiscal resources on supporting flows of new lending and new funding to support new lending, rather than on supporting stocks of existing bad assets and/or toxic assets assets and on guaranteeing or insuring stocks of existing liabilities, the state meets its three key objectives.  First, its short-run economic stabilisation and crisis-fighting objective; second, its medium and long-term banking sector incentive-enhancing, moral-hazard-minimising objective; and third, its fairness objectives: the polluter pays or, you break it, you own it.

Establishing legal and institutional clear water between the legacy bad banks and the new good banks is a necessary condition for fulfilling the economic imperative to support flows of new lending and borrowing rather than to protect existing stocks of toxic assets and their owners.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website