The US Treasury requests volunteers for suicide; any takers?

According to today’s Financial Times, “Tim Geithner warned on Sunday that the US government would consider ousting board members at American banks as a condition for giving the institutions “exceptional” assistance in the future.”

The next time I teach Econ 101, Economic Principles – Microeconomics, I will use this as a school book example of how not to structure incentives.

When a bank is undercapitalised and new lending and borrowing are encumbered by an overhang of bad, dodgy or toxic assets, the one thing you should not do is offer public financial support to rectify this situation on terms that are very painful for the key decision makers in the banks, painful that is, for those who decide on whether to accept the state’s financial aid.

Perhaps you believe that the CEOs, CFOs, COOs, other top executives and board members whose recklessness, incompetence and misfeasance brought the banks they were responsible for (and for which they indeed had a fiduciary duty) to the edge of the precipice (and at times beyond it) are likely to commit personal professional and financial suicide by doing the right thing for the bank and the wider community,  accepting public money even when doing so will result in their being fired.  If you do, you probably invested all you money with Bernie Madoff.

This point has been made many times before, as has the point that if the state wants to recapitalise banks and clean up their balance sheets, it has two options.  The first is to make acceptance of state money voluntary – at the discretion of (in order of importance) the management of the bank, the board of directors, the unsecured creditors and the shareholders.  In that case, the terms have to be easy on those in a position to veto the deal.  The state effectively gives the money away.  This was the approach adopted thus far by the US authorities vis-à-vis its large banks.  After the first, tough tranche of financial support, it was also the approach adopted by the US authorities vis-à-vis AIG, after the first tough tranche of financial support.

The second approach is to make the terms painful for the decision makers.  In that case, acceptance of financial support has to be mandatory, not a choice of the incumbent management and board.  This can be accomplished in many ways.  Full nationalisation is one way.  Putting the wonky banks into a special resolution regime would be another.  In an SRR with promp corrective action powers, the management and board can be fired by the Conservator/Administrator, the unsecured creditors can be forced to take a haircut or can be metamorphosed into shareholders, and most prior contracts and obligations are null and void or at least open for renegotiation  (including pension obligations, golden parachutes, severance pay etc. commitments etc.).

Or the government can simply announce a list of banks that will have to take government financial assistance, willy-nilly, and whose management, boards, shareholders and unsecured creditors will be subject, as a result of this mandatory financial transfer, to various potentially painful sanctions/interventions.

Instead, the US Treasury is now following the UK and German example by trying to be a little bit pregnant: offer state money, make it painful and expensive for the incumbent management, board and other vested insider interests, but keep it voluntary.  I am sure they are going to be lining up in droves to take advantage of this unique opportunity to do the right thing.

What is going on in the Obama economics team?  Has no-one on Pennsylvania Avenue heard of incentives?  They even have, during a short interlude of enlightenment, given themselves the tools to do the job properly.  The Financial Stability Plan includes, as one of the three key components of the Financial Stability Trust, ”A comprehensive Stress Test for Major Banks” (the other two components are “Increased Balance Sheet Transparency and Disclosure” and the “Capital Assistance Program”.

With an army of recently laid-off financial experts and toxic asset wizards at the disposal of the US Treasury to implement the comprehensive stress tests for major banks, surely the US authorities must know by now which bank needs public money and how much.  Tell those banks identified as both in need of public money and capable of using it in the public interest (possibly after a change of management and board leadership) to take the money.  Don’t ask. Tell.

It isn’t hard.  Take a leaf from Winnie the Pooh.  Pooh was a bear of very little brain, but at least he had courage.  Or from the Wizard of Oz, a literary reference perhaps closer to those in charge (but not in control) of US economic policy, take a leaf from the Scarecrow and the Cowardly Lion.  With a little bit of brain power and a little bit of courage, this crisis can be overcome.

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

Maverecon: a guide

Comment: To comment, please register with FT.com, which you can do for free here. Please also read our comments policy here.
Contact: You can write to Willem by using the email addresses shown on his website.
Time: UK time is shown on posts.
Follow: Links to the blog's Twitter and RSS feeds are at the top of the page. You can also read Maverecon on your mobile device, by going to www.ft.com/maverecon