The lending performance of Irish and other European banks might be improved by the creation of asset management companies to absorb banks’ toxic assets and replace them with cash or near-cash assets. The types of toxic assets held by banks differ across European countries; they are mostly bad property loans and collateralized-mortgage-based securities.
There will be a considerable decrease in banks’ accounting book value when it sells toxic assets for cash value since the toxic assets are being carried on the banks’ accounting books for more than their true market value. The decrease in accounting book value, which will come out of the banks’ book value of equity, has to be modest enough so that the banks are not declared insolvent after the transaction.
The Geithner plan offers a valuable template for Europe in designing a toxic asset transfer scheme. The Geithner plan invites private firms to bid competitively for the toxic assets of US banks. The funding for the bids come from three sources: equity provided by the bidding firm of 3% to 10% of total capital provided, an equal amount of equity funding provided and owned by the US government, and a non-recourse US government loan for the remaining 80-94% of capital provided. The required yield on the nonrecourse loan will be somewhat underpriced relative to its risk, so there is some degree of subsidy. This is necessary to make the plan work; this entire subsidy should in theory accrue to the selling bank and shore up its capital base. This is the only subsidy in the plan.
Since the US government will own up to 97% of the asset management companies’ assets, there is considerable financial/administrative/legal expertise needed by the government to provide reasonable oversight of these asset transfers and subsequent management of the assets. This could make such a plan problematic if implemented by Ireland on its own. Also, it is critically important that there are multiple bidders, competing aggressively against each other in the toxic asset auctions. Additionally, the nonrecourse loan must come from a government entity borrowing at risk-free rates (and then lending to the asset management company at a higher rate). It is a clever type of “targeted quantitative easing” (my own term). Ireland is not in a position to borrow vast sums to purchase the toxic assets of its own banks. The targeted quantitative easing should come from the sovereign issuer of our currency.
This is a great opportunity for the European Central Bank to play a role as a true regional central bank. It can easily provide the non-recourse debt in a European version of the Geithner plan. National governments can be responsible for the matching equity investment, and the ECB can provide the oversight, along with national governments. Implementing the Geithner plan in Europe would also appease the US government which wants to see some burden sharing by European governments in dealing with the credit-liquidity crisis.
Krugman feels that the Geithner plan, although moving in the right direction, is too weak to be effective. However if the EU joined the US and instituted a very similar plan there might be a positive-feedback effect on confidence and liquidity which could boost the global impact.
Originally published at The Irish Economy blog and reproduced here with the author’s permission.