How Washington can prevent ‘zombie banks’ - My Critique

James Baker, Reagan and Bush’s former Chief of Staff and renown political advisor, recently wrote a column in the Financial Times proposing measures to stymie bank’s insolvency. I present a critique of his argument. Note that the italized sections of this missive represent Mr. Baker's words, while the bold sections represent my refutations.

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Beginning in 1990, Japan suffered a collapse in real estate and stock market prices that pushed major banks into insolvency. Rather than follow America’s tough recommendation – and close or recapitalise these banks – Japan took an easier approach. It kept banks marginally functional through explicit or implicit guarantees and piecemeal government bail-outs. The resulting “zombie banks” – neither alive nor dead – could not support economic growth.
A period of feeble economic performance called Japan’s “lost decade” resulted.Unfortunately, the US may be repeating Japan’s mistake by viewing our current banking crisis as one of liquidity and not solvency. Most proposals advanced thus far assume that, once confidence in financial markets is restored, banks will recover.
But if their assumption is wrong, we risk perpetuating US zombie banks and suffering a lost American decade.

[This assumption is in fact wrong. We are headed into a prolonged decline. Complicating matters more, the U.S. is in a worse financial condition in comparison to Japan when undertaking the zombie operations.]

Evidence – a mountain of toxic assets, housing market declines, a sharp economic recession, rising unemployment and increasing taxpayer exposure through guarantees, loans, and infusion of capital – strongly suggests that some American banks face a solvency problem and not merely a liquidity one.

[Agree. The majority of banks requiring government fund are de facto insolvent. If this were not the case, then they would not uphold themselves to onerous additional regulations simply to obtain cheaper funding.]

We should act decisively. First, we need to understand the scope of the problem. The Treasury department – working with the Federal Reserve – must swiftly analyse the solvency of big US banks. Treasury secretary Timothy Geithner’s proposed “stress tests” may work. Any analyses, however, should include worst-case scenarios. We can hope for the best but should be prepared for the worst.

Next, we should divide the banks into three groups: the healthy, the hopeless and the needy. Leave the healthy alone and quickly close the hopeless. The needy should be reorganised and recapitalised, preferably through private investment or debt-to-equity swaps but, if necessary, through public funds. It is time for triage.

[I see no necessity to involve public funds in any rescue package, as this will perpetuate the moral hazard. Moreover, would anyone like to try to test the exclusivity of the too-big-to-fail idea? What if Citi of BoA would be the one dissolved? I doubt politicians would let the market take its adequate course.]

To prevent a bank run, all depositors of recapitalised banks should be fully guaranteed, even if their deposit exceeds the Federal Deposit Insurance Corporation maximum of $250,000 (€197,000, £175,000). But bank boards of directors and senior management should be replaced and, unfortunately, shareholders will lose their investment. Optimally, bondholders would be wiped out, too. But the risk of a crash in the bond market means that bondholders may receive only a haircut. All of this is harsh, but required if we are ultimately to return market discipline to our financial sector.

[For the most part, I agree. Bank runs in our time are a highly improbable event because it would mean everyone at the same time would eschew depositing currency in and removing deposits from financial institutions. A bank might fail from a run, but if that money is deposited in another bank, the system survives.]

This is not a call for nationalisation but rather for a temporary injection of public funds to clean up problem banks and return them to private ownership as soon as possible. As president Ronald Reagan’s secretary of the Treasury, I abhor the idea of government ownership – either partial or full – even if only temporary. Unfortunately, we may have no choice. But we must be very careful. The government should hold equity no longer than necessary to restructure the banks, resume normal lending and recoup at least a portion of taxpayer investment.

[The trouble is that once an industry comes under the claw of government bureaucracy, it is challenging to undue it. And when they do de-nationalize, there is a tremendous risk that the process will be conducted politically. That is, the ripe fruits would go to those politically connected.]

After replacing bank management with new private managers, the government should have no say in banks’ day-to-day operations.

The FDIC can assist. Just this year, it has placed more than a dozen American banks – admittedly all small – into receivership. We might also consider setting up something akin to the Resolution Trust Corporation, created in 1989 to liquidate the assets of failed savings and loans. The RTC eventually disposed of almost $400bn in assets of more than 700 insolvent thrifts.
To avoid bank runs and contain market disruption, the Treasury should announce its decisions at one time. Washington will also need to co-ordinate its actions with other major capitals, especially in western Europe and east Asia. At best, this will encourage other countries to take similar steps with their own banking systems. At a minimum, other governments can prepare for the financial turmoil associated with the announcement.

[It is difficult to see politicians who rarely agree on anything substantive suddenly consent to engage in such a complicated operation.]

This approach is not pretty or easy. It will cost a lot of money, with the lion’s share coming from US taxpayers, at least in the short to medium term. But the alternative – a piecemeal pumping of more public money into insolvent banks in the vague hope that things will improve down the road – could truly be historic folly.

Eventually our banks and economy will start to recover. When they do, we would be wise to avoid another Japanese mistake – raising taxes. To counter mounting debt created by government stimulus packages, Japan increased taxes in 1997. Consumption dropped and the country’s economy collapsed.

Our ad hoc approach to the banking crisis has helped financial institutions conceal losses, favoured shareholders over taxpayers, and protected senior bank managers from the consequences of their mistakes. Worst of all, it has crippled our credit system just at a time when the US and the world need to see it healthy.

[But aren’t these some of the consequences of government manipulation in any sector? All government involvement in economic activity produces a winner and a loser. Both will lobby hard, given that they recognize rent seeking is the way to increase profits, not capital investment and productivity.]

Many are to blame for the current situation. But we have no time for finger-pointing or partisan posturing. This crisis demands a pragmatic, comprehensive plan. We simply cannot continue to muddle through it with a Band-Aid approach.

[To use a bit of sarcasm to highlight the error in this statement consider your response to a doctor who will treat your symptoms without analyzing what caused it. That will not assist us in preparing the cure for our malady, correct? We need to finger-point the culprits, otherwise we may have a case where the lunatics are running the asylum.]

During the 1990s, American officials routinely urged their Japanese counterparts to kill their zombie banks before they could do more damage to Japan’s economy. Today, it would be irresponsible if we did not heed our own advice.

[A Biblical Proverb says that like a dog returns to its vomit, so a fools returns to his folly. Fools have been in charge in this country for quite a while. The same folks who never saw this crisis coming are the ones cheerleading when presumably “green shoots” are visible and are advising the end of the recession is nigh. Fortunately, reality cannot be mocked for too long. Or like Moses once utter, “be sure your sin will find you out.”]