All New Deal Bankers?
by Warren Coats
Issue 105 -April 9, 2008

Thanks for your well considered thoughts on the Fed in your editorial, “All New Dealers Now”? I broadly share them but would like to give a somewhat different slant to two points.

The Fed’s actions with Bear Sterns are very similar to the orderly demise of the 905 banks in the late 80s that you mention. Just imagine so many bank failures without the economy collapsing (as it did during the Great Depression). Bear Stern’s exists no more (or will soon be gone) and the market was spared potentially serious disruption. The U.S. has developed a very efficient approach to bank failure that actually makes it tolerable and acceptable for a bank to fail. In most parts of the world, without these tools, governments just aren’t willing to risk a bank failure. They are always bailed out.

While I was at the International Monetary Fund, we convinced most Central and Eastern European transition countries to let insolvent banks fail, but they are the exception. So we should cheer the way Bear Sterns was allowed to leave the market. My concern is that it should not really be the Fed that takes the risk--that the collateral they took will not cover the value of the loan they made. The Treasury should take that risk as they did with the 905 banks you mentioned (through a cooperative arrangement between OCC and FDIC).

The second point is whether the Fed’s policy is now too easy (fed funds rate too low). You are certainly right that we can’t and shouldn’t try to prevent business cycles that correct imbalances in the economy and yes the Fed largely caused this one (housing bubble) along with fiscal deficits that kept the dollar over-valued for too long to encourage the rest of the world to finance our deficit. These imbalances need to be corrected and there will be or is a recession, but maybe a mild one.

But the Fed should try to prevent over-reactions, which are also common in market economies. This is what they are trying to do on two fronts. First, they are trying to prevent shifts in risk assessments and preferences from freezing up financial markets. They are fighting a good fight on this front. They are not increasing liquidity but trying to prevent its collapse as banks horde liquidity (increased demand for bank excess reserves). Liquidity, measured as the adjusted monetary base (basically the monetary liabilities of the Fed), has steadily declined over the last five years and has increased less the 2 percent from a year earlier.

“The drop in the fed funds rate is a different matter and is trying to soften the business cycle (not prevent it, I hope). The Fed has lowered its policy rate (fed funds interbank lending rate) very rapidly to 2.25%. I am inclined to think they are overdoing it some.

Warren Coats of Bethesda MD is an international banking consultant and former associate at the International Monetary Fund

Warren : Thanks for your very intelligent remarks. But I don’t see why the Treasury should bear the risk either. The stockholders should. I also believe opening the loan window to non-bank firms does increase liquidity whether it is measured as such or not. More “money” (loans) is/are made available than otherwise “exists” (that is, is not being used elsewhere). A big reason the market cannot be “managed” is that such measures are rough at best (Hayek) if not useless (Mises). I am afraid inflation is already getting close to uncontrollable. Gold is the only thing going up—at an obscene rate at that. As you said in another of your postings, gold is not perfect but it is telling us something very important now, I am afraid. Best, Don

Don, Yes, the shareholders should pay first, but that is easier said than done. Normally the only way to force owners to take the loss is through the process of bankruptcy. Generally bankruptcy is initiated by an unhappy creditor when a firm can’t pay its bills, i.e. when it is illiquid. If it can’t get a loan in the market to enable it to pay its bills it is probably insolvent as well. This is a good market test. But insolvency is hard to prove except after the fact and that is what bankruptcy is all about. Bankruptcy is a process of taking the firm from the owners and paying off the creditors under court direction. The firm shuts down and a liquidator takes control and sells off the assets. Only then can we know if it was insolvent or not. If not, the owners get something back (but not ownership of the firm, which no longer exists), if yes, the creditors loss the difference as a result of not being fully repaid.

This process just doesn’t work for banks where creditors are largely depositors who can withdraw their funds (or try to) at any time. Increasingly countries, following the imperfect but pretty good U.S. example, except banks from bankruptcy laws and establish a special regime just for banks. Northern Rock is a good example of the problem when such special provisions don’t exist. Northern Rock could not be sold without the agreement of the stockholders who where not willing to accept a zero price (which if it were insolvent is all they should get). Thus nationalization was the only sensible approach. By nationalizing Northern Rock the state had to compensate the stockholders for the value of what was taken, but if the bank was insolvent (negative capital), that would be zero. Then the state could sell the bank back to the private sector for whatever it was worth to the market.

This is tricky stuff in part because there is no objective measure of the value of a bank’s assets other than from selling them (i.e. the bankruptcy process). What a good bank bankruptcy law should provide is for the regulator (in the U.S. case the insurer – FDIC) to talk over the ownership of the bank when it is judged insolvent (giving shareholders nothing) and to quickly sell it as a going concern (rather than closing its doors, locking up deposits until individual loans could be sold or collected). But generally, and certainly in present market conditions, potential buyers will pay a much better price if the risks to the value of the bank assets can be limited. The regulator or insurer that took over the bank should have a better idea of the ultimate value of the bank’s loan portfolio than potential buyers (they have had more time to examine it) and thus by guaranteeing their value (usually at something below book value) will save the taxpayers money (this assumes that the depositors are made whole) from the better sale price. An even bolder approach would allow the FDIC to give haircuts to depositors and other credits as part of the resale of the bank (actually the FDIC sells some or all of the assets to the buyer for which the buyer assumes all or most of the deposits – a purchase and assumption transaction). The whole thing is done over a weekend and the depositors are just informed on the next business day of the name change or ownership change and can move their deposits elsewhere after that as they like. In short, the whole process of bankruptcy liquidation (with out the requirement of public auctions of assets etc) is compressed into a weekend or a few days without serious interruption to the use of depositor funds. The idea that depositors would discipline banks because they might lose funds in bankruptcy never really worked. As I said in my earlier note very few governments were willing to risk the clean and pure closing of the bank via traditional bankruptcy. But the FDIC approach has worked very well. It does involve the state taking on some risks (unless you give depositors haircuts, which the FDIC never has). My point was that this risk should be taken by Treasury, i.e. tax payers in order to keep discipline in the process. The central bank can just print money, which is too easy and thus might cloud its judgment about when and what to guarantee. Finance Ministers really do care about protecting tax payers.

There is potential abuse in this system and it needs checks and balances but also needs to be somewhat heavy-handed with stockholders to be efficient. Without it we never could have closed so many banks with so little disruption.

On the second point about loans increasing liquidity: Yes, the loan increases liquidity, but the Fed has been taking it back elsewhere by selling t-bills to the market thus over all liquidity has not been increasing much. A second point is that if banks want more liquidity than before because of risk concerns (we would say the desired excess reserves has increased), which is what is happening when banks stop or reduce lending to each other and just keep those funds, then the Fed needs to increase the supply of reserves just to keep liquidity conditions the same. Warren

Warren , You make excellent arguments but I still disagree. It seems to me—in theory and practically--the risk should not be to the Treasury but to the stockholders, depositors, creditors, etc, in a “bankruptcy” solution (whether normal or special for banks)—and with haircut authority. I agree the Fed is not the right place. Today, FDIC is a mixed animal—partially an insurer which can take to bankruptcy (properly) and partially a government bail-out and risk accumulator. On FDIC Gary North says the reserve at the time he looked at it was listed at $44 billion or 1.5% of the insured assets (today it is down to 1.2%) —but it was only $34.7 billion on the Balance Sheet, of which only $12 billion was available for sale—and these (and all of the rest) were in government securities!! So you don’t have to worry, the Treasury is already on the hook and will have to come up with money it does not have. FDIC can meet some of the risk but it just does not have much money. A private insurer that had this little reserve would be in jail. Best, Don

Don, We are agreed on the first best solution, but almost no country has been willing to take the risk of applying it. My second best is much better than the usual bailout. I am a pragmatist. Warren