Too failed to live not too big to fail
The U.S. policy of keeping zombie financial institutions alive is so clearly failing that it is now attracting attack from inside policymakers’ circle of covered wagons.
The most interesting intervention in the banking debate in the past few weeks was an extraordinary attack by Kansas City Federal Reserve President Thomas Hoenig on what he termed a policy of “piecemeal” nationalization which leaves discredited management in place, repels new capital from the banking system and allows bad assets to fester rather than be cleared.
This is no academic who can be dismissed as having a poor grasp of the major systemic consequences of letting the big zombies fall, this is the man who has been a Fed president for 17 years and has a deep history in banking regulation, deeper and with more practical experience arguably than the people making the policies in Washington.
“If an institution’s management has failed the test of the marketplace, these mangers should be replaced. They should not be given public funds and then micro-managed, as we are now doing under TARP, with a set of political strings attached,” Hoenig said.
In short, it’s not an ideological attack on runaway market forces but a collection of sensible practical considerations that should limit the ideologically based decisions now being made.
And be in no doubt; administration policy as laid out by Treasury Secretary Tim Geithner, Fed chief Ben Bernanke and White House economic advisor Larry Summers has as its core a fervent commitment not to take into state control large insolvent institutions, preferring instead to essentially bear the risk and the cost without having a clear line of accountability for day-to-day bank actions.
They are in essence going down the route Japan took in the 1990s, keeping banks alive and hoping they will earn their way out of the capitalization hole. And, to be fair, the yield curve in the U.S. is a lot steeper than it was in Japan, meaning that banks will earn on the difference between their funding costs and the longer-term rates they charge customers.
But there is are quite a lot of opportunity costs built into that strategy, even if it is convenient in avoiding temporary public ownership of large parts of the banking system.
These costs may only make themselves apparent in retrospect, if we find ourselves in two years time with a struggling banking system that still can’t intermediate capital effectively. More likely those costs will become uncomfortably visible in only months. Despite protestations from Citigroup and others that they are producing profits, there is a real danger that the unpredictable and ad hoc way in which banking is being bailed out scares depositors and, more to the point, bond buyers and clients into withdrawing their money, business and credit from ailing banks.
That’s how this will play out, not by the U.S. administration suddenly going all five year plan on us, but being forced to step in by events caused partly by their own inability to inspire confidence.
A GREAT TIME TO BE A BANK, PITY ABOUT THE COMPETITION
That is the sad irony, in many ways it’s now a pretty good time to be a bank, only you want to be one without legacy assets. Somebody should be making fat margins, what with there being less competition and a steep yield curve.
But why on earth would you commit funds to the banking system when you have no credible view on how capital will be treated by government going forward. I’d be scared witless that my equity ends up being forced into making all sorts of lousy loans for political purposes, or that as a bondholder I am ultimately forced to take equity when the losses become too big for even government, or that I face competition from some zombie with government funding and non-economic marching orders.
None of these are avoidable problems. But what we could do is deal with them quickly, share out the pain transparently and move on. And just because some of the insolvent institutions are huge doesn’t mean they can’t be handled. As it stands the incentives for banks are to be too big to fail, and to be “independent” but pliable.
Hoenig points out that the Depression-era Reconstruction Finance Corporation at one point held capital in 40 percent of all U.S. banks but because it was aggressive in writing down assets to realistic levels and turfing out failed management was able to do it without any net cost to government or taxpayers.
But for that to happen we have to write down assets to their clearing price, not prop them up so that we can pretend we all still live in 2006. If you do that, banks and the economy have a chance, capital will return, loans will be made where they make sense and growth eventually will return.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. —