It Isn’t That Hard

It Isn’t That Hard
February 6, 2009

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at He may be reached at


The FDIC on January 27 proposed a change in the restrictions on interest rates that institutions that are “less than well capitalized” may pay on deposits to prevent moral hazard behavior by zombie institutions. The notice of the proposed change goes on to note that “(T)he proposed rule applies only to the small minority of banks that are less than well capitalized. As of third quarter 2008, there were 154 banks that reported being less than well capitalized, out of more than 8,300 banks nationwide.”

Something isn’t right here. If there are only a handful of institutions that are inadequately capitalized, then why are we talking about buying bad assets from banks, or establishing a “bad” bank to house those assets and potentially commit another several hundred billion (maybe as high as two trillion) dollars of taxpayer money to support banks? This disconnect has plagued the handling of the financial crisis in financial institutions from the outset and continues to be a problem that has to stop.

It isn’t that hard to put the system on a sound footing, and it has been done before by others. The Scandinavian countries experienced a financial crisis that resulted in nationalization of most of the banks; and the episode, its successes and failures, have been aptly described in a book by Thorvald Moe, Jon Solheim, and Bent Vale, entitled The Norwegian Banking Crisis, published by the Norges Bank in 2004. The parallels between their crisis and ours and the problems with how it was handled are sobering, and it appears that we have learned nothing from their experience.

What needs to be done can be summed up quite succinctly in three simple steps. Some might object that these proposals may be too costly, but it seems we have already crossed that bridge and now it is time to get some bang for our spending.

Step 1. Losses Must Be Identified.

Loss identification should be the job of management. After all, they granted the loans and/or purchased the assets and are closest to the source. If management won’t or can’t do it, then it is the responsibility of the regulators as part of their supervisory activities. Unfortunately, management hasn’t done its job and neither have the supervisors.

Step 2. Losses must be written off against common equity.

Carrying unrecognized losses creates uncertainty about institutional solvency and is at the heart of the breakdown of the interbank market and the decline in bank stock values. Furthermore, avoidance of loss recognition by relying upon government guarantees only creates moral hazard incentives and behaviors and encourages increased risk taking. Again, it is the responsibility of management and bank supervisors to see that not only are losses identified, but also written off. So far all we have seen is serial loss identification and recognition, with no end in sight. No wonder institutions are having trouble funding themselves.

Step 3. Insolvent institutions must be closed, reorganized, recapitalized, and reprivatized.

Policy makers and regulators have been paralyzed by the fear of so-called systemic risk and by concerns that some institutions are “too –big –to fail.” Note that I didn’t suggest that institutions should be liquidated. What the Nordic countries did was to inject government capital into their major institutions, but only after losses had been identified and taken by shareholders. Management was replaced and a plan was put in place to reprivatize the institutions. Those institutions left standing were soundly capitalized for which there was no uncertainty about their financial condition. Only after losses have been recognized will the public and financial markets be assured that the existing institutions are healthy, regardless of whether they are privately owned or temporarily government owned. Confidence can be restored only by such actions. Unfortunately, this is not the path we have taken, and it now looks like we are bent on throwing good money after bad, under current proposals.

A Bad Bank as Proposed Is a Bad Idea

Current proposals to establish a “bad bank” that would buy, hold, and liquidate bad assets, perhaps in combination with additional guarantees of losses on retained assets, are likely to be expensive and not solve the fundamental problems. As it stands, the bad bank idea is nothing but reconstitution of the original idea in the TARP, with all its associated problems. The sticking point before was how to price the assets that are acquired, which boils down to loss sharing between the taxpayers and the institution’s debt and equity holders. Pay the current market value (or some very low price), and equity has to be written down, which risks forcing the institution into insolvency. Pay too much, and the taxpayer gets the loss. Then there is the problem of monitoring the asset maintenance and/or liquidation process, especially if some of the assets remain on bank balance sheets subject to loss guarantees. Granting loss guarantees is equivalent to letting people with no equity stake in their homes to continue to live there free. We know what that does to incentives to maintain the property.

One proposal being floated by the administration is to have the “bad bank” buy only assets that have written down. But someone isn’t thinking. If the assets have already been written down, then they are no longer bad assets, unless they haven’t been written down enough. This would leave the selling bank with only the remaining questionable assets in which all the risks reside. This will do nothing to assuage market uncertainty about the viability or soundness of the institution, and hence will not restore the smooth functioning of the interbank market or lower risk spreads. Coupling the purchase of bad assets with a government guarantee would only create uncertainty about the quality of remaining assets on the books and the ability of the institution to go it on its own without continued government support. This is a band-aid covering up the wound. Guarantees also have the added problem that they imply there is no exit policy in place for removal of government support.

A “bad bank” only makes sense to hold assets after reorganization and recapitalization has already taken place. Existing shareholders would be wiped out, and questionable assets would be taken over and managed by the FDIC or some other entity, where true costs to the taxpayer can be scored and their performance monitored and assessed. Dividing a bank into a “good” bank and “bad” bank also avoids the accounting nuances that have served as a deterrent to loss recognition. Management and shareholders are then left with the sole responsibility for running the good bank, and presumably, taxpayers would be granted warrants and/or equity to participate in the upside as recovery occurs. It just isn’t that hard!

Copyright 2008, Cumberland Advisors. All rights reserved.

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