My ‘Good Bank’ proposal (see (1), (2), (3), and (4), and related proposals by Joseph Stiglitz, George Soros and Paul Romer) appears to be getting some attention if not yet traction in a number of European capitals and in Washington. There are a couple of questions about the proposal that crop up regularly, and I would like to address these here. They are (1) how do you set up a good bank, and (2) would not the senior unsecured creditors of the old bad bank be likely to take a hit under your proposal?
In a private note about my ‘good bank’ proposal , Uwe Reinhardt raises the following question: “..physically and time wise, how hard would it be to establish these new banks? … People will imagine new skyscrapers being built to house the new banks, etc. So, step by step, how would this get done? I imagine one could just take over Citigroup’s and Morgan Stanley’s buildings, make it the new bank and move the <bad stuff> that stays with them to another location — or , <worse>floors in the same building.”
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.