Friday, March 27, 2009

Toxic Liabilities Instead of Toxic Assets

Assuming that financial contagion due to large insolvent banks is a problem that needs to be dealt with, then here's an interesting proposal by Bulow and Klemperer that would have avoided bailing out financial institutions that were at the source of the crisis and therefore shouldn't stay afloat for economic and moral reasons. They argue that instead of buying toxic assets the government should have "bought" toxic liabilities (HT Mankiw). This is a summary of the proposal:

1. We cannot efficiently value or transfer “toxic” assets - so a good plan cannot depend upon this.

2. The UK’s Special Resolution Regime, or one similar to that of the US FDIC, can cleanly split off the key banking functions into a new "bridge" bank, leaving liabilities behind in an "old” bank, thus also removing creditors’ bargaining power.

3. Creditors left behind in the old bank can be fairly compensated by giving them the equity in the new bank.

4. We can pick and choose which creditors we wish to “top up” beyond this level, but should not indiscriminately make all creditors completely whole as in recent bailouts.

5. Coordinating actions with other countries will reduce any risks.

As we pour good money after bad in trying to save the banks, far too much time and attention has been focused on attempting to value or transfer or shore up the so-called “toxic” assets. This is natural enough, since they arguably caused the crisis, but it’s also wrong. ...

A plan that isolates the bad liabilities rather than the bad assets of the banks, and pays the owners of those claims everything they legally deserve in liquidation but does not fully immunise them from losses, will achieve three major objectives.

  • It will help unfreeze the credit markets by creating healthy banks able to lend.
  • It will assure that depositors are paid in full, and all creditors are paid at least their entitlement.
  • It will make the bailout cheaper for the government, increasing its flexibility.

Finally, as an additional benefit, paying creditors based on market values rather than government guarantees reduces moral hazard in bank finance, and increases the prospect of better monitoring by sophisticated private creditors in determining the future allocation of capital across financial institutions.

There will be a lot more we will need to do to solve the financial crisis -- let's not make the bank bailouts more expensive than absolutely necessary.

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