Bad Bank Babbling

Following a heated discussion on various bad bank proposals (as documented in the various links in this post), I thought it might be helpful to summarize the various ways that problem banks can be dealt with:

1. Muddling through

The "simplest" option is to do nothing: Solvency standards are relaxed, accounting standards changed, in the hope that the problem will eventually go away. After all, if the banks are profitable with their new business, they will eventually earn enough to cover the current hole, right?

The advantage: No courageous and difficult political action is required

The problem: Bank customers are not stupid. Especially not now, after all that has happened. So they will be extra-careful, and refuse to do business with any shaky bank that doesn't receive comprehensive government guarantees. And that means: If things work out well, and future profits start flowing, they will eventually flow to shareholders again. Whereas if things don't work out well (if the hole is simply too big to be filled), the taxpayer is on the hook.

In other words: Socialize losses, privatize the gains.

There are several variations of "muddling through":

a) Do absolutely nothing

Simply allow the banks to go on with their business. If they can raise additional capital on the market, they should. Whereas if they can't, the government has to extend guarantees to keep the customers happy. Discussion: See above.

b) Create bank-specific "bad banks" without external help

In other words, banks put their toxic assets in newly created subsidiaries / SPVs. As long as they get no outside guarantees, and no external party buys any of the assets, this doesn't change anything: The bank still owns the same assets, they are simply one legal layer removed. "Smoke and mirrors", in other words. The vanSuntum proposal is part of this category.

c) Create an industry-wide "bad bank" without external help

This is the Enigma/Blick-Log proposal: Banks have to pool their bad assets in an industry-wide captive insurance pool. This is better than a/b, because it eliminates the non-systematic risk (that one bank's bad assets perform worse than average). However, the systematic risk (that the total industry's bad assets perform worse than expected) remains.

In my impression, the systematic risk element of the current mess is much more important than the non-systematic risk. Therefore, while I believe that this proposal helps a bit, I also believe that it doesn't go far enough: If the overall hole turns out to be too big for the industry to handle, the taxpayer needs to step in to socialize the losses. Whereas if the hole turns out to be smaller than expected, the shareholders of the various banks get to privatize the profits.

Oh, and there's also a technical problem: You need to allocate the various assets to "risk classes" and assign insurance premium payments to each class. This is highly subjective, and once you force companies to take part, there will be endless haggling about "fair" premiums (with every bank insisting that its main asset categories are less risky than other banks main asset categories). While you can set the premiums ex-post based on actual incurred losses, that obviously reduces the insurance-element of the scheme: If asset class A ends up with huge losses, and asset class B ends up with small losses, and you retroactively assign huge premiums to class A and small premiums to class B, what happened to "insurance"? You'd effectively have separate insurance pools for separate assets, and that would sharply reduce the desired spreading of risks between the various banks.

2. Remove problem assets

The government can acquire the problem assets, or "insure" them (i.e. guarantee them against a fee). There are essentially two approaches here:

a) Pay "fair value" and/or charge a "fair fee".

The advantage: If the prices are indeed "fair", there is no wealth transfer from taxpayer to shareholders.

The problems: First of all, who determines the "fair" bit? With all the political pressure, subjectivity all too easily translates into intransparent fighting among lobbyists and interest-groups. Secondly (and quite possibly even worse): It's quite likely that a removal of assets at "fair value" means that many banks are insolvent. Which brings us back to scenario 1, i.e. the taxpayer havnig to guarantee the downside (otherwise, the insolvent bank cannot survive), whereas potential upside can still go to the shareholders.

b) Pay a "generous value" and/or charge an "affordable fee".

The advantage: The banks become more healthy, insolvency risk recedes.

The problem: The taxpayer pays for it all, and the shareholders can rejoice.

IMHO, this is by far the worst of all possible options.

3. Nationalization

If a bank cannot meet a reasonable solvency standard (based on reasonably honest accounting rules), shareholders are asked to provide additional capital. If no private investor is willing to commit additional capital, this proves that private investors consider the bank's fair value to be negative. Therefore, it can be nationalized without any compensation for existing shareholders.

The advantage: From then on, it's "left pocket, right pocket", no more wealth transfer from taxpayer to shareholder. If there is any long-term upside, the taxpayer gets it in return for taking care of the current mess.

The problem: If the hole is big, the cost for the taxpayer is big. But it's still better than filling the hole and giving parts or all of the upside to the shareholders (as is the case in options 1 and 2).

As for corporate governance: Politicians are not good at running companies. That's obvious, and the Landesbanken mess is just the latest reminder. So it would be important to minimize political meddling and to make sure the banks are managed like private companies. It would probably help to have them report to the finance/economics ministries in Berlin, as opposed to state presidents. Ensures at least a minimum level of economic/business know-how that seems to be completely lacking on a state-level (if the Landesbank debacles are any guide).

And yet another, long-term caveat: When the banks are eventually reprivatized, care needs to be taken that they are not sold off too cheaply.

4. Controlled insolvency

The most radical proposal: Why should the bleeding be limited to the shareholders and the holders of hybrid capital? Why do unsecured creditors need to be protected? Sure, "normal" bank deposits are sacred. Too many political promises have been made, and it makes sense to protect the "little man". Secured creditors are also protected, because they have their collateral. But unsecured creditors can take losses.

In other words, the banks should enter insolvency proceedings. That doesn't mean they should close down. Business can and should continue, but creditors need to accept a haircut, quite possibly a severe one. It happens all the time in other industries, why not in banking?

The advantage: Taxpayer cost is minimized. It might still cost something if the hole turns out to be really huge, but definitely far less than in all other options.

The problem: It would be the end for nearly every Western financial institution (as in: none of them would survive with its present ownership structure intact). Much (if not most) of unsecured debt is held by other banks and insurance companies. It was hard enough for the system to survive the Lehman collapse. Any more big institutions to go down that route, and all the dominoes will be falling. It would take a lot of political courage to effectively restart the world financial system from zero. And it would take extensive international cooperation and agreement: Once one big country goes down that route, it effectively forces all other countries to go along (Think AIG: If the US had not propped up AIG with government funds, Deutsche Bank would apparently have lost 13 bn $. Game over for Deutsche Bank). The international repercussions could be huge, because some countries would lose out, and others would gain. As for Germany, there's an additional aspect to consider: The biggest part of the problem are the Landesbanken. Can the government as owner of these banks really refuse to inject more capital and to let unsecured creditors bite the bullet? Is it politically feasible to let state-owned banks screw up and then pretend they are limited-liability companies, bye-bye and thank you very much?

Summing up:

IMHO, option 4 is the most consistent one from a theoretical point of view. It would also be the fairest one, because it places the pain with the investors (which bought shares and bonds of their own free will), not with the taxpayer. But it's not politically feasible. Way too complicated. So the "smallest evil" is probably option 3, i.e. nationalization (without paying anything to shareholders and hybrid capital owners). Options 1 and 2 involve unnecessary and inappropriate transfer of wealth from taxpayer to shareholders.