Friday, September 21, 2012

Sheila Bair: were bank bailouts

In a Fortune article on Sheila Bair's new book, Ms. Bair asks the question was it necessary to give the nation's biggest banks billions in new capital in the fall of 2008.  Her response is no.

More importantly, Ms. Bair focuses on the need for full information.

Regular readers know that a modern banking system is designed so that it never needs to be bailed out. The reason that banks do not need to be bailed out is with deposit insurance and access to central bank funds they can continue to operate and support the real economy for years even with negative book capital levels.

Deposits insurance effectively make the taxpayers the bank's silent equity partner when the bank has low or negative book capital levels.  As a result of this partnership, banks can continue to operate, retain their earnings and rebuild their book capital levels.

This design has one other major benefit.  It allows banks to absorb all the losses on the excess debt in the financial system and protect the real economy.

Your humble blogger refers to the choice to require the banks to absorb the losses and not bail them out as the Swedish model.  The Swedish model has succeeded everywhere it has been tried with Iceland being the most recent example.

I refer to the choice to protect bank book capital levels and banker bonuses by engaging in policies like bailouts as the Japanese model.  The Japanese model has failed everywhere it has been tried with the EU, Japan, UK and US as examples.

In retrospect, the mammoth assistance to those big institutions seemed like overkill. I never saw a good analysis to back it up. But that was a big part of the problem: lack of information.
The reason there was never a good analysis to back up the bailouts is because the financial system is designed so that the bailouts are unnecessary.

What is necessary is information.

Your humble blogger has been calling for ultra transparency since the beginning of the financial crisis.  It is only when the banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details that the risk and solvency of the banks can be truly assessed.

It is only with ultra transparency that market participants can adjust their exposures to each bank based on the market participant's independent assessment of the risk of the bank.

It is the adjustment of the market participants' exposures that exerts market discipline on the banks.  Riskier banks face a higher cost for funds and lower risk banks are able to access funds less expensively.
When you are in a crisis, you err on the side of doing more, because if you come up short, the consequences can be disastrous.
Actually, by erring on the side of doing more, the consequence have been predictably disastrous.

By bailing out the banks, the losses on the excesses in the financial system were transferred to the real economy.  The result has been a disaster as the real economy struggles to deal with the burden of carrying all this excess debt.  A burden that did not need to be placed on the real economy.

For example, Iceland made its banks absorb the losses and the financial crisis is behind it as its economy is growing, unemployment is falling and its social safety net has been expanded.

Can the EU, UK or US say that?
The fact remained that with the exception of Citi, the commercial banks' capital levels seemed to be adequate. The investment banks were in trouble, but Merrill had arranged to sell itself to BofA, and Goldman and Morgan had been able to raise new capital from private sources, with the capacity, I believed, to raise more if necessary. 
Without government aid, some of them might have had to forgo bonuses and take losses for several quarters, but still, it seemed to me that they were strong enough to bumble through. 
Citi probably did need that kind of massive government assistance (indeed, it would need two more bailouts later on), but there was the rub. How much of the decision-making was being driven through the prism of the special needs of that one, politically connected institution? Were we throwing trillions of dollars at all the banks to camouflage its problems? Were the others really in danger of failing? Or were we just softening the damage to their bottom lines through cheap capital and debt guarantees? 
Granted, in late 2008 we were dealing with a crisis and lacked complete information. But throughout 2009, even after the financial system stabilized, we continued generous bailout policies instead of imposing discipline on profligate financial institutions by firing their managers and boards and forcing them to sell their bad assets.
The system did not fall apart, so at least we were successful in that, but at what cost? We used up resources and political capital that could have been spent on other programs to help more Main Street Americans. And then there was the horrible reputational damage to the financial industry itself. It worked, but could it have been handled differently? That is the question that plagues me to this day.
It is still not to late to impose discipline on the banks by adopting the Swedish model.

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