Monday, January 26, 2009

The Good Bank Solution

One solution to the financial crisis that is currently being discussed is the so-called “bad bank solution”. What this means is that the government would set up an entity, and gather all the toxic assets that the banks have, so that the bank system can be freed of the bad stuff and move on. Sounds good, but where do the losses go? The answer is: to the American people.

This solution is no different from the original TARP plan, in that the American taxpayer simply gives banks money to cover all the mistakes those banks made, with no strings attached. I believe that the losses in the banking system are too great for a bailout like this one to have the potential to work, regardless of the moral implications. That is why we need a different solution.

First, a reality check to illustrate my point. Bank of America and Citigroup are the two large banks that are in the worst shape. Consider their market value in 2007 compared to today:

Bank of America’s market value in the second quarter of 2007: $228 Billion

Bank of America’s market value in January 2009: $33 Billion

Citigroup’s market value in the second quarter of 2007: $255 Billion

Citigroup’s market value in January 2009: $15 Billion

In addition to this, these banks have several times their market value in toxic assets, which means that they are effectively insolvent already. Consider also what Bank of America did after it received bailout money: it went and bought MORE mortgage-backed securities, creating even greater losses. When the bank found out that it was going to get a bailout, it started paying huge bonuses to its executives, in reality using TARP money for that. It’s definitely time to stop betting on the losing horses. It doesn’t matter how much money we spend on these banks, they’re not going to be able to continue in their current forms. The bad bank solution is nothing more than a bad solution.

I am instead proposing a Good Bank Solution, under which the government sponsors entirely new banks, completely untainted by the crisis and the toxic assets. Instead of trying to repair a complete wreck of a bank, a new one is constructed from scratch. The public could then safely put its money into those banks, investors could invest money in them, and the banks could immediately start lending with prudent standards. More specifically, the plan would consist of the following steps:

1. The government drafts a bank charter (the rules for the bank), and includes very stringent standards on lending, how much capital the bank must have, how the bank can invest, how much money the bank must lend, and so on.

2. The government puts money into the bank. We’re talking about billions of dollars, not billions in losses, but in investments in a new banking system with a clear potential for profit. The government owns 100% of the bank.

3. The bank opens for business, takes customer deposits and starts lending immediately. Investors will be able to buy 49% of the stock, but the government must remain the majority shareholder for a few years until the financial crisis has been resolved. By selling stock, the government may already have recouped half of the investment at this stage, potentially at a profit.

The government can create many of these banks, and in one fell swoop bring confidence and lending back. It is important to note that this is just a temporary solution. Once the crisis has passed, these entities can be sold completely, so that the government does not have to act as a banker.

Before that happens, the government will also have been given time to legislate the new financial regulation that is so direly needed. The “good banks” don’t need regulation, because they will have that written into their charters. This would be a big operation for sure, but it must be done, because the current system is broken.

Share your thoughts in the comment section.


seev said...

How politically feasible is this very sensible (to me) sounding plan? What is to be done with the present management of BofA and Citi, for example. Could they be recruited to run the new banks? Or is this just placing incompetents in charge? But how else to get such a plan realized?

Jacob said...

I think the biggest problem for politicians right now is that they don't really know what to do, and they don't understand the problem. For that reason I don't know if the plan is feasible. However, my plan is much cheaper, so in that way it would be very feasible.

During a bank crisis, there is traditionally no place for the current bank management. Governing lesson number 1 for bank crises is to let them retire with their millions and immediately promote middle management employees who have spent years at the bank.

M.G. said...

I had that idea already in October 11th, 2008. Try to convince Obama's team...Prof. W. Buiter is now also suggesting it, Soros is also urging U.S., let's see if this proposal get momentum and understanding.