On new banks.

February 12, 2009 § Leave a comment

Let’s Start Brand New Banks

A clean slate would keep TARP money away from bad banks.


Everyone agrees that the United States urgently needs a few good banks. Turning bad banks into good banks is a difficult and risky way to get them. It’s simpler and safer to start entirely new banks.

In this context, “good” means a bank with assets and liabilities that are easy to value using market prices. At a good bank, officers, regulators and investors can be confident about the value of the bank’s capital.

The government has $350 billion in Troubled Asset Relief Program (TARP) funds that it can use to encourage new bank lending. If this money is directed to newly created good banks with pristine balance sheets, it could support $3.5 trillion in new lending with a modest 9-to-1 leverage. Right out of the gate, the newly created banks could do what the Fed has already been doing — buying pools of loans originated by existing banks that meet high underwriting standards.

If the TARP funds go to existing banks, much of them will end up stuck in financial institutions that are still bad after the transfer. We know from the previous round of TARP that giving more capital to bad banks generates very little net new lending.

Proposals for turning existing banks into good banks — recapitalizing them, nationalizing them, transferring the toxic assets off their balance sheets, or insuring the toxic assets — require prices for all these hard-to-value assets or, worse still, prices for derivative contracts on the toxic assets. (Calling the derivatives “insurance” doesn’t make them any easier to price.) Without reliable market prices for the hard-to-value assets, any proposal for turning bad banks into good banks could lead to huge transfers of wealth between taxpayers and bank shareholders.

If the government lets new banks provide the new lending that the economy needs, it could return to clearly stated and familiar policies for bank regulation. The government could announce that it will not invest any new capital in a troubled bank that it hasn’t yet taken over. Nor will it offer troubled banks any transfers or implicit subsidies. It can stick to a policy of assigning accurate values to assets as new information comes in. It can follow the usual FDIC procedures for protecting depositors and taxpayers and for deciding when to take over a distressed bank, and managing careful workouts that avoid the turmoil that a Lehman-style bankruptcy proceeding can cause.

With a return to a clearly articulated and familiar pattern of bank regulation, investors from the private sector could invest in the banking sector without fear that they will be competing with zombie banks that receive ongoing subsidies and transfers from taxpayers. Provided that the government accelerates the approval process, investors from the private sector can quickly create the new banks that the government backs. Over time, they can also buy the government’s shares in these banks. Investors from the private sector can also invest in existing banks that truly are good banks.

The government should move first and signal unambiguously that new banks with at least $350 billion worth of capital will enter the market quickly. Over time, the private sector will deliver on this commitment. The government’s role is merely to act as a temporary bridge.

There are, to be sure, risks of political interference from government involvement in banking, but all of the current proposals for increasing lending require more government involvement. The challenge is to find one that increases lending and does the least harm.

If the government starts as a shareholder in new, healthy banks that eventually end up entirely in the hands of the private sector, the political risks start small and diminish. If instead the government combines open-ended and opaque financial support for troubled banks with promises of tight supervision and punishment for bad behavior, the risks are large and grow over time.

The brewing backlash against the existing players from the financial sector is almost certain to burn hotter as the recession wears on, and new election campaigns get underway. If the new administration ties its fate to the existing players, it could lose its room to maneuver on countercyclical policy and be put under political pressure to intervene in bank decisions in ever more intrusive ways.

Because they can and will borrow, new banks will be much more effective in leveraging TARP funds. They will undertake more total lending, bring more trading to financial markets, and do more to limit the depth of the recession. As a result, investing the TARP funds in new banks will do more to help the troubled but potentially viable existing banks than giving funds directly to them.

Banks that are not viable, the ones with liabilities that substantially exceed their assets, will lobby vociferously against a return to historical patterns of bank regulation. They will say anything to postpone a looming FDIC takeover. The administration should not listen to threats and pleas from these doomed banks. It does not have to rely on them to get new lending going quickly and on a large scale. New entrants could give us a few good banks. That, plus an FDIC that can do its job, is all we need.

Mr. Romer is a senior fellow at the Stanford Institute for Economic Policy Research.


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