Getting healthy banks to buy troubled ones

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.

Originally published at the FT and reproduced here with the author’s permission.

2 Responses to "Getting healthy banks to buy troubled ones"

  1. DJC   October 14, 2008 at 4:15 pm KONG: The $2.5 trillion combined bailout has aroused the resentment that surfaced during the Asian crisis a decade ago at a global financial architecture perceived, with some justice, to be weighted against Asians.The deputy governor of China’s central bank, Yi Gang, recently castigated the International Monetary Fund for its almost total failure to put any teeth into surveillance of those countries – the United States and Britain – enjoying the reserve-currency status that makes it easier to run deficits. As he rightly noted, “weak financial-policy discipline resulted in excess global liquidity and disorderly capital flows.”This should not be news. The unwillingness of the IMF to try to discipline these countries – America and Britain in particular – has been remarked upon often enough in these columns. It now makes a particularly poignant contrast to the IMF’s zeal for dispatching experts from Washington to discipline other countries’ economies – developing ones in particular. The humiliation of President Suharto of Indonesia in 1998 by the head of the IMF, Michel Camdessus, is not forgotten in Asia.As many Asians see it, the IMF and the London and New York capital markets have one rule for the old, rich, English-speaking nations and another for Asian upstarts. Doing something about that, however, requires a degree of solidarity not yet evident in the region.

  2. Kiers   October 15, 2008 at 7:39 pm

    I couldn’t disagree MORE! You state: “The sale of Bear Stearns to JPMorgan in March is a good example of this method.” THese are two DISPARATE entities! I think the BIGGEST MISTAKE Bernanke has done is to merge Investment Banks with Depository Banks. Investment Banks, we all know, were big proprietary trading (ie. Betting) institutions (like hedge funds). What is the ECONOMIC significance of a BET???BETS, like the “investments” made by I-Banks into derivatives ONLY redistribute wealth. Derivatives are a ZERO SUM GAME. For every ONE loser there is ONE opposite WINNER. Does NOTHING for the ECONOMY.And Bernanke has taken all the gambling garbage of CDOs, synthetic CDOs, CDS’s of Merrill, Bear, and STUFFED them to DEPOSITORY BANKS!! HOW IS THAT FOR TRANSPARENCY. These gambling I-Banks were failing due to their own non transparency; and Bernanke (w/o any discussion or PAUSE) put that into depository public! All the while the US media keeps talking about TARP buying “mortgages”…Actually TARP wanted to rescue the same CDO, CDS BETS made by former I-Banks, (now become depository banks). And what, PRAY, is the economics of buying derivatives to HELP THE UNDERLYING????I mean readers of this site are financially intelligent: CAN YOU RAISE EQUITY IN A COMPANY, OR SUPPORT ITS STOCK PRICE, BY BUYING ‘CALL’ OPTIONS? PRAY TELL? NO? Then what’s the USE of buying useless CDOs to help “mortgages” as the mass media misuses the term!!WHAT A JOKE. BERNANKE AND PAULSON, AND THAIN AND BLANKFEIN, AND GREEENBURG AND MACK should at least be metaphorically TARRED in public and not celebrated and continue on in their jobs!!!!thank you.