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Tough Love Time for US Banks

by | February 23rd, 2009 | 10:16 am

The US Treasury reportedly will begin strict examinations of the 20 biggest American banks’ balance sheets starting this week. If anything close to current asset values are used to evaluate those books, and they should be, many of these banks will need public capital injections or closure. The reluctance to pull the trigger appears to be based on the fact that such forced write-offs would require the unpopular steps of another injection of public funds and/or a round of closures, either way involving government ownership of those banks, aka nationalization. Failing to be so strict and leaving current shareholders and top management in control, however, will just lead to further losses of taxpayer dollars and recurrent suspicions about some banks’ viability, as we saw in the stock market last week.

Implementing the write-off of the bad loans should follow what is now a reasonably standardized sequence from other countries’ and past US banking crises. See for example what I recommended for Japan in 2001, which was largely and successfully implemented by Japanese financial services minister Heizo Takenaka in 2002–03. Yes, the banks in question are very large and extremely systemically important. But as Japan demonstrated, it is possible to have public stakes and even control of large money-center banks, and still have them largely continue doing their business as usual—minus the incentives to gamble with taxpayer money rolling over bad loans.

And all this talk about the difficulty of doing the balance sheet assessments rapidly with available staff is at best losing the forest for the trees, and at worst an excuse. There is no shortage of unemployed financial analysts looking for consulting work, and there is no need to be all that caught up in getting precisely the “right” price on various distressed assets. Pricing the illiquid assets will inherently be arbitrary, and any underpricing can be made up for with greater capital injection on the other side, but doing so when the government controls the institutions preserves the full upside for the US taxpayer from eventual privatization. The implementation difficulties are surmountable, as they were in other countries and in the S&L crisis of the 1980s. Furthermore, what have the bank supervisors of the FDIC, Federal Reserve Banks, et al. been doing for the last several years if not having some sense of these banks’ balance sheets?

The key is for bank supervisors to truly count and publicly recognize the extent of the bad loans, using market signals about the worth of various assets. Those banks whose losses exceed their capital are shut down, with bank shareholders losing all their equity and depositors being reimbursed up to deposit insurance limits. Those banks that have positive but too little (i.e., below prudential standards) capital after taking loan losses are either merged with other, more viable banks or are recapitalized by an infusion of public funds, which are conditional on certain performance requirements. Private shareholders again take a loss through dilution, with some equity shifting at least temporarily to the public sector. Also, foreclosed collateral (aka distressed assets) is sold off.

On purely economic terms, the undercapitalization, the nonperforming loans, and the fact that we are coming off of an unsustainable bubble in intra–financial sector debt issuance should prompt the Obama administration to close, break-up, or merge many of the largest US banks. Though the political pressures may prevent this from occurring, the Treasury and the FDIC (and the Federal Reserve) must make clear to the public that the American banking sector must shrink. The surviving banks, including those with public funds, will be forced to pay off the loan losses over several years, absorbing most profits. American taxpayers will in the end have to pay the lion’s share of capital injections into the banking system and the deposit insurance payouts, though they will get back much of the money from the sale of currently distressed bank assets and privatization of the banks.

We have to take this first step now, before events force a panic about some of the suspect banks. That would only cause more damage, create negative spillovers on the viable banks, and lead to nationalization anyway at higher net cost to the taxpayer. We also need a bad bank, preferably publicly held, to buy the bad assets, but that will be the easier part politically and economically. What we definitely do not need are “forward-looking stress tests” of the banks used to justify regulatory forebearance, because in some future world the banks’ balance sheets will be solvent. That asks for trouble, as we saw in the United States in the 1980s and Japan in the 1990s (see Japan’s Financial Crisis and Its Parallels with US Experience ).

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