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The real difference between Iceland & Ireland (Cormac Lucey), & “How to abandon the common currency for a new national currency” (Nyberg)

Cormac Lucey, Sunday Times, 19/III 2017
At the height of the financial crisis, Michael Noonan stated that “Ireland is not Iceland”. Rather than stating the obvious, at a symbolic level Noonan was making clear that he didn’t intend Ireland to follow the same route as Iceland in terms of burning bank bondholders. So what happened in Iceland, and what lessons, if any, can our closest northwestern neighbour offer us?
… In Ireland we deployed €65bn of state funds to prevent our banks going bust. Much of that money ended up paying foreign creditors of our banks. This was done after the European Central Bank president Jean-Claude Trichet phoned Michael Noonan from Frankfurt and warned that if foreign creditors were burnt “a bomb will go off, and it won’t be here, it will be in Dublin”. Let the record show no bomb went off in Reykjavik when it successfully burnt foreign creditors.
Moreover Ireland is not Iceland, as Iceland retained currency and monetary sovereignty. A halving in the value of its currency restored international competitiveness. Ireland pooled its currency and monetary sovereignty with its eurozone partners. Following the outbreak of crisis, the euro rose against those of our main trading partners, especially sterling. That strengthened deflationary forces here and contributed significantly to Ireland’s economic woes.
Despite having a population of only a third of a million, Iceland asserted its independence by retaining its own currency and aggressively promoting its national interest in the banking crisis. Ireland submerged its independence in a continental currency and had to meekly follow the Nuremberg doctrine in obeying orders from Frankfurt.

Read more: http://cormaclucey.blogspot.com/2017/03/independent-iceland-teaches-great-deal.html

The following linked paper, co-authored by Peter Nyberg (“the same Finnish former civil servant picked by the Irish government  to report on how the banking system here collapsed”), was referred to in the second (postscript) piece in Cormac Lucey’s column, in the above-mentioned Sunday Times (Irish edition) Business Section.

Malinen, Nyberg, Koskenkylä, Berghäll, Mellin, Miettinen, Ala-Peijari, Törnqvist, How to Abandon the Common Currency in Exchange for a New National Currency (October 4, 2016). Available at SSRN: https://ssrn.com/abstract=2847507 or http://dx.doi.org/10.2139/ssrn.2847507http://dx.doi.org/10.2139/ssrn.2847507


The question of how to leave a monetary union has become an important economic issue during the last few years. Uncertainty relating to its costs tends to discourage political leaders from taking decisive steps towards an exit. This article provides thoughts on what the necessary steps are, what are the associated pitfalls, how they can be overcome, and how can an exit from a currency union be effectively managed to control associated risks and costs. Uninterrupted functioning of the payments system, political response and the solvency of the private and public institutions are shown to be the major determinants of the costs of an exit. Issues of public governance, such as legality of the exit, can become an issue only if political and public support for the exit is lacking.

Read more: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2847507

⁂ Two important articles on the Banking crisis

Is America the new Russia?
The Financial Times
By Martin Wolf

Ruminations on banking
Professor Willem Buiter
The auto-da-fé of the unsecured creditors is coming to a US bank near you…
Too big to fail means too big…
The repatriation of cross-border banking…

⁂ Banks capture Governments at taxpayers’ expense . . .

Below for your information are some points relevant to Ireland’s current Banking crisis and Finance Minister Lenihan’s proposed NAMA “bad bank” scheme which are excerpted from an article by Willem Buiter, Professor of European Political Economy, London School of Economics. The full article, dated yesterday, 8 April, titled “The green shoots are weeds growing through the rubble of the ruins of the global economy”, may be found on Professor Buiter’s Financial Times blogsite at ft.com/maverecon


The green shoots are weeds growing through the rubble in the ruins of the global economy

by Willem Buiter

April 8, 2009

The Great Contraction will last a while longer

This financial crisis will end. The Great Contraction of the Noughties also will come to an end. But neither the financial crisis nor the contraction of the global real economy are over yet. As regards the financial sector, we are not too far – probably less than a year – from the beginning of the end. The impact of the collapse of real economic activity and of the associated dramatic increase in defaults and insolvencies by non-financial enterprises and households on the loan book of what is left of the banking sector will begin to show up in the banks’ financial reports at the end of the summer and in the autumn. By the end of the year – early 2010 at the latest – we will know which banks will survive and which ones are headed for the scrap heap. With the resolution of the current pervasive uncertainty about the true state of the banks’ balance sheets and about their off-balance-sheet exposures, normal financial intermediation will be able to resume later in 2010.

Governments everywhere are doing the best they can to delay or prevent the lifting of the veil of uncertainty and disinformation that most banks have cast over their battered balance sheets. The banking establishment and the financial establishment representing the beneficial owners of the institutions exposed to the banks as unsecured creditors – pension funds, insurance companies, other banks, foreign investors including sovereign wealth funds – have captured the key governments, their central banks, their regulators, supervisors and accounting standard setters to a degree never seen before.

I used to believe this state capture took the form of cognitive capture, rather than financial capture. I still believe this to be the case for many, perhaps even most of the policy makers and officials involved, but it is becoming increasingly hard to deny the possibility that the extraordinary reluctance of our governments to force the unsecured creditors (and any remaining non-government shareholders) of the zombie banks to absorb the losses made by these banks, may be due to rather more primal forms of state capture. (emphasis in bold added)

History teaches us that systemic financial crises are protracted affairs. A most interesting paper by Carmen M. Reinhart and Kenneth S. Rogoff, “The Aftermath of Financial Crises”, using data on 10 systemic banking crises (the “big five” developed economy crises (Spain 1977, Norway 1987, Finland, 1991, Sweden, 1991, and Japan, 1992), three famous emerging market crises (the 1997-1998 Asian crisis (Hong Kong, Indonesia, Malaysia, the Philippines, and Thailand); Colombia, 1998; and Argentina 2001)), and two earlier crises (Norway 1899 and the United States 1929) reaches the following conclusions (the next paragraph paraphrases Reinhart and Rogoff).

First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent over six years; real equity price declines average 55 percent over a downturn of about 3.5 years. Second, the aftermath of banking crises is associated with large declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, but the duration of the downturn averages around 2 years. . .

. . . Conclusion

There are signs that the rate of contraction of real global economic activity may be slowing down. Straws in the wind in China, the UK and the US hint that things may be getting worse at a slower rate. An inflection point for real activity (the second derivative turns positive) is not the same as a turning point (the first derivative turns positive), however. And even if decline were to end, there is no guarantee that whatever growth we get will be enough to keep up with the growth of potential. We could have a growing economy with rising unemployment and growing excess capacity for quite a while.

The reason to fear a U-shaped recovery with a long, flat segment is that the financial system was effectively destroyed even before the Great Contraction started. By the time the negative feedback loops from declining activity to the balance sheet strenght of what’s left of the financial sector will have made themselves felt in full, financial intermediation is likely to be severely impaired.

All contractions and recoveries are primarily investment-driven. High-frequency inventory decumulation causes activity to collapse rapidly. Since inventories cannot become negative, there is a strong self-correcting mechanism in an inventory disinvestment cycle. We may be getting to the stage in the UK and the US (possibly also in Japan) that inventories stop falling an begin to build up again.

An end to inventory decumulation is a necessary but not a sufficient condition for sustained economic recovery. That requires fixed investment to pick up. This includes household fixed investment – residential construction, spending on home improvement and purchases of new automobiles and other consumer durables. It also includes public sector capital formation. Given the likely duration of the contraction and the subsequent period of excess capacity, even public sector infrastructure spending subject to long implementation lags is likely to come in handy. A healthy, sustained recovery also requires business fixed investment to pick up.

At the moment, I can see not a single country where business fixed investment is likely to rise anytime soon. When the inventory investment accelerator goes into reverse and starts contributing to demand growth, and when the fiscal stimuli kick in, businesses wanting to invest will need access to external financing, since retained profits are, after a couple of years of declining output, likely to be few and far between. But with the banking system on its uppers and many key financial markets still disfunctional and out of commission, external financing will be scarce and costly. This is why sorting out the banks, or rather sorting out the substantive economic activities of new bank lending and funding, that is, sorting out banking, must be a top priority and a top claimant on scarce public resources.

Until the authorities are ready to draw a clear line between the existing banks in western Europe and the USA, – many or even most of which are surplus to requirements and have become parasitic entities feeding off the tax payer – and the substantive economic activity of bank lending to non-financial enterprises and households, there will not be a robust, sustained recovery.
(emphasis in bold added)

⁂ The Banking Crisis – how to solve it: Statement & Relevant articles by Financial Times economist Willem Buiter

The Banking Crisis: Set up temporary “good” State Banks to lend to businesses and households and let the existing insolvent Irish Banks go bust

The present policy of Ireland’s mainstream politicians will lead to economic bankruptcy to be followed by political bankruptcy
The Irish Banks are fundamentally insolvent without continual infusions of Irish taxpayers’ money.

However the Government, supported by Fine Gael, has decided to keep them alive indefinitely.

That way the Banks can continue to pay their creditors and bondholders who lent them vast sums that fuelled the 2001-2007 borrowing binge, and keep hope alive amongst their shareholders that the value of their shares will recover sometime in the future.

As a consequence Irish businesses and households are at present being starved of credit, causing belt-tightening and job losses, in order to keep the Bank of Ireland, AIB and the rest of them alive as “zombie banks” at Irish taxpayers’ expense.

Bank nationalisation is not the answer. That would transfer ownership of the Banks’ bad assets to Irish taxpayers, and impose on them the job of repaying the Banks’ debts.

What the country really needs is one or more “good” State Banks to be set up from scratch in order to take over the essential function of credit provision to society on the lines proposed by Financial Times economist Willem Buiter and Nobel Economics Prizewinner Joseph Stiglitz, as well as by financier George Soros (see Buiter’s articles at ft.com/maverecon and four of them copied below for your informaton).

Ireland had State Banks in the past: the Industrial Credit Corporation and Agricultural Credit Corporation.

The best way of freeing credit to normal Irish business and households without expecting taxpayers to protect Bank bondholders and shareholders from the results of their feckless past lending and improvidence, is to establish such “good” State banks, which could be privatised later if desired.

These would be free of the dud and artificially inflated assets which clog up lending by the existing private Banks. The new “good” Banks could be capitalised by public money as well as the currently State-guaranteed deposits in the existing private Banks. The depositors in the latter would of course move to the new “good” Bank.

The laws of the free market should then be let take their course, so that the insolvent Irish Banks and their improvident managements would move into bankruptcy or be restructured by means of special Government legislation.

Letting the insolvent Bank of Ireland, AIB and the rest of them go bankrupt will bring down radically the price of land, houses and commercial property, which is currently being artificially inflated by the Banks’ exaggerated loan-book valuations.

These unrealistic values in turn are underpinned by Finance Minister Lenihan’s largesse, for which Irish taxpayers will be expected to pay more and ever more for years ahead – indefinitely rewarding the Banks’ incompetence and recklessness.

The “good” State Banks can take over the buildings and much of the staff of the existing Banks to administer the new clean Banks and the State can withdraw its guarantee of the liabilities of all existing Banks, which it was folly to have agreed to last September in the first place.

This foolish act by a handful of politicians put Irish taxpayers into hock indefinitely for the benefit of the Banks that were the main instrument of the crisis, the builders and developers to whom the Banks lent money, and the politicians themselves, who set the administrative-political framework for the borrowing binge.

Although it is unfashionable to remind people, these are the same politicians whose uncritical europhilia brought us into the eurozone, even though Ireland is unique among the 16 eurozone countries in doing two-thirds of our trade outside it and our exports are now sagging in face of the fall in sterling and the likely fall in the dollar as the Obama administration deluges the American economy with money.

We are now caught in the vice of the eurozone, unable to regain economic competitiveness by devaluing our currency in the way the UK and Sweden can – countries that are full EU members but are not in the eurozone. Instead we must devalue our wages and salaries, profits, pensions and social welfare payments for years to come as our politicians point the Irish people towards valleys of pain ahead. Is is a fact that abolishing the national currency and joining the eurozone was the basic cause of Ireland’s credit explosion.

Floating the Irish púnt between 1993 and 2000 and the highly competitive exchange rate that gave us was what gave birth to the “Celtic Tiger” economy of the 1990s.

When did the Irish growth rate double to 7% from the 3-4% average it had been from the 1960s to the early 1990s?

In 1993, the year of the devaluation of the Irish púnt – which Bertie Ahern, Finance Minister at the time, strove manfully to resist, supported by SIPTU’s Billy Attley.
When was the only period in the history of the Irish State that it followed an independent exchange rate policy, effectively floating the currency and giving priority to the real economy rather than to maintaining the exchange rate?

From 1993 to 2001, when our annual economic growth rate averaged nearly 8%.

We already had a boom and house prices were rising rapidly when we joined the eurozone – and cut interest rates by half. This was the opposite to what the real economy needed. No wonder house prices rocketed as we shifted gears from exporting abroad to house-building at home and credit hugely expanded.

The eurozone will give us permanently low interest rates,” said ESRI economist John FitzGerald, Garret FitzGerald’s son, in 2000. We are now experiencing the results of that policy.

Having effectively bankrupted the Irish economy, the same politicians are now preparing to bankrupt us politically.

Through the Treaty of Lisbon they are seeking to turn the Irish State into a region within a European Federation and turn us all into real citizens of an EU political Union.

This would subordinate us from 1 January 2010 to European laws, in making which Germany’s voting weight in the EU Council of Ministers would more than double from its present 8% to 17%, that of France, Britain and Italy would grow from 8% to 12% each and Ireland’s vote would be halvedfrom 2% to 0.8%.

These laws would in turn be exclusively proposed by a non-elected EU Commission on which Ireland would lose the right to decide who its national Commissioner would be. This post-Lisbon EU would be able to decide the rights of 500 million EU citizens, including us Irish, and would be given the power to impose any tax on us without the need for further Treaties or referendums.

Is this generation of Irish people fated to follow the failed politicians that rule us over a political cliff as well as an economic one, like the proverbial lemmings?

Anthony Coughlan

Below are four articles for your information on the “Good Bank” concept of Financial Times economist Willem Buiter. See the reference to Ireland, with emphasis added in bold type, in the first article below. These and other relevant articles may be found on Buiter’s Financial Times web-site: ft.com/maverecon


Good Bank/New Bank vs. Bad Bank: a rare example of a no-brainer

February 8, 2009

The truth of a proposition is independent of how many people believe it to be correct. The merits of a proposal are likewise not enhanced by the number of people supporting it or making similar proposals. Still, humans, like other pack animals, thrive on companionship. It is therefore comforting that the logic behind my proposal (January 29, 2009) for one or more new ‘good banks’ to be established, capitalised with public money and with additional financial support from the state for new lending and new funding, while the toxic assets of the old banks are left with the owners and creditors of the ‘legacy banks’, is being echoed in proposals from Joseph Stiglitz (February 2, 2009), George Soros (February 4, 2009) and Paul Romer (February 6, 2009), to name but a few.

I claim no authorship or originality for the ‘good bank’ proposal. The idea is obvious and no doubt was floating around the blogosphere and elsewhere as soon as the magnitude of the insolvency disaster in the banking sector became apparent.

The various proposals differ in detail. Romer’s proposal is essentially the same as my own. Stiglitz argues, according to the British Daily Telegraph that “the government should allow every distressed bank to go bankrupt and set up a fresh banking system under temporary state control rather than cripple the country by propping up a corrupt edifice“.

Soros proposes not to remove the toxic assets from the banks’ balance sheets (which would require them to be valued, which is not possible) but instead put them into a “side pocket”. The necessary amount of capital – equity and unsecured debentures – would be sequestered in the side pocket. Soros’ ’side pocket’ is effectively the same as my ‘legacy bad banks’. Soros notes that about $1.5 trillion is likely to be required to recapitalise the existing banks properly. This money could be leveraged a lot more effectively if most of it were injected into the new good banks, unencumbered with the toxic waste of the existing banks.

Under the Soros proposal, some additional capital might have to be injected into the ’side pockets’, presumably by the state. Under my new good banks proposal, the new good banks would take on the (guaranteed or insured) deposits of the legacy bad banks (which would lose their banking licenses) and would buy the good assets of the legacy banks. Should deposits exceed good assets, the state would have to make up the difference initially with government debt on the balance sheet of the new good banks. Should deposits be less than good assets, the new good banks would be able to borrow from the sovereign to finance the acquisition of the good assets from the legacy bad banks. This would cleanse bank balance sheets and transform them into good banks but leave them undercapitalized. Soros suggests that $1 trillion of the estimated $1.5 trillion required to recapitalise the existing banking system should be directed to the cleansed banks. Soros believes or hopes that some of the money required to capitalise the new, cleansed banks could come from the private sector. Under my proposal, and that of Stiglitz, the state would initially capitalise the new banks on its own.

A common logic

The logic is simple. Many (probably most, possibly all but a handful) high-profile, large border-crossing universal banks in the north Atlantic region are dead banks walking – zombie banks kept from formal insolvency only through past, present and anticipated future injections of public money. They have indeterminate but possibly large remaining stocks of toxic – hard or impossible to value – assets on their balance sheets which they cannot or will not come clean on.

This overhang of toxic assets acts like a tax on new lending. Banks are required, by regulators or by market pressures, to hoard capital and liquidity rather than engaging in new lending to the real economy. The public financial support offered in the form of capital injections (in the US mainly through preference shares and other non-voting equity), guarantees for assets and for liabilities (old and new), insurance of toxic assets (as provided to Citigroup by the US sovereign) and possibly in the future through direct purchases by the state of toxic assets (using TARP money in the US) and the creation of one or more publicly owned ‘bad banks’ has been a complete failure.

The bad bank proposals the Obama administration and other governments are considering are non-starters, for the simple reason that they require the valuation of assets whose true value (even on a hold-to-maturity basis) can only be guessed at. The good bank proposal only requires the valuation of those assets on the balance sheets of the existing banks that are easy to value: transparently valued assets. The toxic stuff is left on the balance sheet of the existing banks, which become the legacy bad banks.

Offering to pay enough to the existing owners of the toxic assets to induce these owners to sell them would require paying over the odds. That might not leave enough fiscal resources to support the new lending activities that are so urgently needed. It would also be an unfair and moral-hazard-maximising bail out of the existing owners and creditors of the banks.

Nationalising the dodgy banks (or even the entire cross-border universal banking sector) would only solve the valuation problem of the new owner (the state) after nationalisation. The toxic assets could be transferred into a bad bank at any valuation, including zero. The owner of the bad bank and of the cleansed bank are the same. Nationalising the dodgy banks would not solve the problem of how much to pay for the banks, however, because that would depend in part on the valuation of the toxic assets. The good bank proposal creates new, publicly owned banks which only purchase good assets from the legacy bank. There is no valuation issue involving toxic assets for the tax payer.

Crisis fighting, moral hazard and fairness

The existing packages of support measures in the US, the UK and elsewhere have failed to get lending to the real economy going again. In the US especially, but also to some extent in the UK, It has been a shameful boondoggle for the banks that are at the heart of the financial mess – bank CEOs and other top managers, bank shareholders, holders of unsecured bank bank debt (subordinated, junior and senior) and other creditors.

The US, the UK and several other continental European countries are at risk of emulating Ireland, where the government first guaranteed all the liabilities of the banks (other than equity) and only after that began to nationalise the banks. This leaves the Irish government today in the not too enviable position of having to choose between sovereign default and bleeding the tax payer and the beneficiaries of normal public spending to make whole all the creditors of the banks. (emphasis added)

Bailing out the holders of existing bank debt and other bank creditors would be outrageously unfair: they did the lending and made the investments, they should eat the losses. In addition, many of the creditors are likely to be much better off, even after they write down/off their claims on the banks, than most of the tax payers and public expenditure beneficiaries that pay for the bail out. Bailing out the existing creditors would also create dreadful incentives for excessive future risk-taking by banks.

Especially in the US, the disdain for moral hazard displayed since the beginning of the crisis by regulators and by the fiscal and monetary authorities has been shocking. It has been justified with the claim that you cannot afford to worry about medium- and long-term incentives for appropriate risk taking when your house is on fire. That argument is logically flawed.

Two things are systemically important. The first is to restore the operation of key financial markets that have become illiquid. The Fed is doing a reasonable job in that regard. The second is to restore bank lending to the real economy. Neither objective requires that the existing banks be saved, let alone that their existing shareholders and creditors receive any financial support from the state. We can save banking without saving the banks or the bankers. The ‘good bank’ proposal demonstrates how to do this.

Regulators, central bankers and policymakers should be pursuing three key objectives. The first is to get lending by the banks to the real economy, especially to the non-financial enterprise sector, going again. The second is to minimize moral hazard by creating the right incentives for future risk taking by banks, their creditors and their customers, by ensuring that the losses incurred by the failed banking system are born first and foremost by those who invested in the banks in any capacity.

For reasons that are partly sensible (protecting small unsophisticated savers from financial ruin and forestalling inefficient attempts by financial illiterates to monitor complex financial institutions) and partly populist pandering, most retail deposits have ended up insured or guaranteed by the state (often at least in part ex-post). Moral hazard should be stopped, however, beyond the magic circle the state has drawn around retail depositors. The third objective is to pursue justice in burden sharing.

The legacy bad banks would, under their existing ownership and with whatever balance sheet they end up with after shedding their insured/guaranteed deposits and after selling their good, easily valued assets, have as their sole activity the management of their existing assets. No new investments would be undertaken, no new loans made and no other new exposures incurred. Their liabilities and other funding decisions would be managed in the interests of the existing shareholders. No doubt many of them would fold. Chapter 11 or Chapter 7 would be ready and waiting for them.


By focusing scarce fiscal resources on supporting flows of new lending and new funding to support new lending, rather than on supporting stocks of existing bad assets and/or toxic assets assets and on guaranteeing or insuring stocks of existing liabilities, the state meets its three key objectives. First, its short-run economic stabilisation and crisis-fighting objective; second, its medium and long-term banking sector incentive-enhancing, moral-hazard-minimising objective; and third, its fairness objectives: the polluter pays or, you break it, you own it.

Establishing legal and institutional clear water between the legacy bad banks and the new good banks is a necessary condition for fulfilling the economic imperative to support flows of new lending and borrowing rather than to protect existing stocks of toxic assets and their owners.


How to set up a new ‘good bank’

February 21, 2009

My ‘Good Bank’ proposal and related proposals by Joseph Stiglitz, George Soros and Paul Romer appears to be getting some attention if not yet traction in a number of European capitals and in Washington. There are a couple of questions about the proposal that crop up regularly, and I would like to address these here. They are (1) how do you set up a good bank, and (2) would not the senior unsecured creditors of the old bad bank be likely to take a hit under your proposal?

In a private note about my ‘good bank’ proposal , Uwe Reinhardt raises the following question: “..physically and time wise, how hard would it be to establish these new banks? Š People will imagine new skyscrapers being built to house the new banks, etc. So, step by step, how would this get done? I imagine one could just take over Citigroup’s and Morgan Stanley’s buildings, make it the new bank and move the [bad stuff] that stays with them to another location – or , [worse] floors in the same building.

Uwe is exactly right as to how the new banks would be established operationally. First, a new good bank is created for each existing bank that is revealed (through the stress tests proposed by US Treasury Secretary TIm Geithner as part of his Financial Stability Plan for all banks with assets over $100 bn, or through some other financial forensic exercise) to be not viable without public financial support. The new good banks would be established as legal entitities and as FDIC-insured commercial banks. They would be capitalised using private and public money, with the state ensuring that the new entities are properly capitalised.

The new good bank (New Citi or New Bank of America, say) would get the deposits of the old bank and it would purchase any of the good assets of the old bank it is interested in. All the bad assets and the toxic (hard or impossible to value) assets would be left with the old bank. If the value of the deposits transferred to the good bank exceeded the value of the good assets it purchased from the old bank, the difference on the balance sheet of the new bank would be made up initially through the acquisition of Treasury bonds and bills. On the balance sheet of the old bank, the difference would be made up through a loan from the state. If the value of the deposits transferred to the good bank were less than the value of the good assets it purchased from the old bank, the difference on the balance sheet of the new bank would be made up initially through the a loan from the state. On the balance sheet of the old bank, the difference would be made up through the acquisition of Treasury bonds or bills.

The old bank would lose its banking license and it would not be allowed to invest in any new assets. The old bank bank would receive no further public financial support of any kind. Government financial support for the banking sector would be restricted to ensuring the new good banks are properly capitalised and guarantees for new lending and borrowing by the new good banks and by those old banks that passed the stress tests.

The bad old bank It would manage the remaining assets of the old bank in the interest of the shareholders of the old bank. Should the old bank fail, the appropriate insolvency protection regime and insolvency regime for the asset management fund that the old bank has now become will be involved. The unsecured creditors (including the holders of senior unsecured debt) would be ad risk. At the very least, some or all of their claims are likely to be converted into ordinary equity. As an old bad bank is no longer in the new lending business and engages in new funding only to maximise the returns from managing (down) the existing portfolio of assets, the old bad banks are of no greater systemic significance than any other asset managers.

Among the good assets I would have the new bank buy from the bad old bank would be as much of the franchises, branches, offices and other real estate and equipment as are necessary to perform the lending, deposit taking and other functions of a (narrow) bank. I would also hire many of the staff (all but the top management) of the old bank. As the old bad bank no longer has a banking license, will no longer hold or take deposits, and will not be allowed to invest in any new assets, it will require just a relatively small number of asset managers and funding specialists to manage its assets. The old or legacy bad bank would just require the expertise of fund managers managing a fund that is constrained not to invest in any new assets.

As far as the banking customers (depositors and borrowers) are concerned, they would at first only notice the change in the name on the door (from Citi to New Citi or from Bank of America to New Bank of America). The legacy bad old bank fund management team could rent some space in the basement of the new bank. The whole exercise could be implemented over a weekend.

The senior debt of many of the institutions that are likely to turn out to be bad banks is often held by institutional investors like pension funds and insurance companies. If and when the old bad banks default on that debt, the holders of the debt obviously get hurt. While that is regrettable, it is surely better that the burden of the losses incurred as a result of past bad lending and investment decisions fall on those who made these decisions rather than on the tax payer.


Slaughtering sacred cows: it’s the turn of the unsecured creditors now

March 18, 2009

Why are the unsecured creditors of banks and quasi-banks like AIG deemed too precious to take a hit or a haircut since Lehman Brothers went down? From the point of view of fairness they ought to have their heads on the block. It was they who funded the excessive leverage and risk-taking of banks and shadow banks. From the point of view of minimizing moral hazard – incentives for future excessive risk taking – it is essential that they pay the price for their past bad lending and investment decisions. We are playing a repeated game. Reputation matters.

Three arguments for saving the unworthy hides of the unsecured creditors are commonly presented:

* Unless the unsecured creditors are made whole, there will be a systemic financial collapse, with dramatic adverse consequences for the real economy.

* If the unsecured creditors are forced to take a hit, no-one will ever lend to banks again or buy their debt.

* The ultimate ‘beneficial owners’ of these securities – notably pensioners drawing their pensions from pension funds heavily invested in unsecured bank debt and owners of insurance policies with insurance companies holding unsecured bank debt – would suffer a large decline in financial wealth and disposable income that would cause them to cut back sharply on consumption. The resulting decline in aggregate demand would deepen and prolong the recession.

I believe all three arguments to be hogwash.


As regards the first argument – financial Armageddon – it may have escaped people’s notice that, with the exception of a few struggling survivors, the large border-crossing banks in the north-Atlantic region would be insolvent but for past, present and anticipated future government financial support. Insolvent financial institutions on opaque tax-payer underwritten life support should instead be put into administration; if they are systemically important, the desired results can be achieved through the special resolution regime (SRR) with prompt corrective action (PCA) that most countries in the region now have in place. A standard and desirable feature of such (proto-) insolvency procedures is the mandatory conversion of unsecured debt into equity and/or the write-down of (part of) the unsecured debt.

The financial market cardiac arrest that followed Lehman’s demise was not evidence that unsecured creditors should be spared. Lehman’s insolvency and liquidation was the correct outcome, but the process was badly mishandled.

First, following the decision of the Fed and US Treasury to arrange for and underwrite the take-over of Bear Stearns by JPMorgan Chase, the market had been lulled into believing (I certainly did), that the US government had underwritten the entire balance sheet of the internationally visible US banking sector. Creating that belief, allowing people to act on it for six months. and then to say ‘well, actually, we did not mean that’ would obviously rattle the nerves of many. Letting the unsecured creditors of other banks and non-bank financial institutions take a hit would not create the same surprise today, judging from the CDS rates for most banks and the default risk premia on bank bonds.

Second, there was no SRR for investment banks at the time of the Bear Stearns crisis. Nor was there at the time of Lehman’s collapse, six months later. The only insolvency option was to put these institutions in Chapter 11 or Chapter 7. That problem no longer exists, because the category of free-standing investment bank to which Bearn Stearns and Lehman belonged no longer has any members. The last two surviving members, Goldman Sachs and Morgan Stanley, became bank holding companies, supervised by the Fed and with the SRR and PCA regime appropriate to such institutions, administered by the FDIC.

Third, even absent a SRR for investment banks, it is extraordinary that the SEC, the Fed and the US Treasury did not between them come up with a way to ring-fence the ‘financial infrastructure services’ provided by Lehman through its role as a custodial counterparty in tri-partite repos. Again, with all major banks now subject to an SRR with PCA, this issue ought not to arise again. I hope that for systemically important non-bank financial institutions, including insurance companies like AIG, there now also exists an SRR, which allows the government to take over the management of the company, with full powers to sell assets, spin off business units and ring-fence subsets of the assets and liabilities.

The Fed’s and US Treasury’s multi-stage bail-out of AIG provided a massive windfall to a particular class of unsecured creditors, owners of CDS written by AIG. About $58 bn was paid out by government-bailed AIG to banks headquartered outside the US. While not all of that money necessarily represents a loss to AIG or to the US tax payer, it is surprising, to say the least, to have official US concern for the well-being of unsecured creditors of US institutions extend to foreign creditors. An admirable manifestation of internationalism.

The global financial cardiac arrest that occurred in the second half of September 2008 (and which now has passed), was in my view due more to the sudden dawning of the realisation that most of the leading border-crossing banks headquartered in the north Atlantic region were insolvent (but for the tax payer’s past, present and future favours), that occurred when AIG had to be rescued. The insurance that banks had bought against default on their bond investments, first from the monolines and then from AIG and similar shadow-banking sellers of shadow-insurance products, turned out to be pretty much worthless.

The fear that followed the markets’ realisation that the banking sector faced an insolvency rather than a liquidity problem did not abate when Treasury Secretary Paulson presented his first TARP proposal to the Congress. This consisted of three A4 sheets, which said: “I want $750 bn. I want it now. I will use these funds for good works, but I cannot tell you what these will be. Don’t ask any questions. And you cannot sue me.” This political blunder convinced many that the Treasury Secretary was out of his depth. When the initial request was turned into a 300 page regular pork-laden Congressional document, the market breathed a sigh of relief. But when Congress then turned down this proposal at the first time of asking, the markets realised that the Congress was childish and irresponsible.

Cardiac arrest seems a reasonable response to this cumulation of bad and worse news. A repeat does not seem likely. Major negative surprises about the health of key financial institutions are unlikely, because health perceptions are already so pessimistic. And compared to the Bush administration, the new administration is unlikely to be as accident-prone in its interactions with the Congress.

Unsecured creditors’ strike

As regards the second argument – if banks default on their unsecured debt, no-one will ever lend to them again – it ought to be unnecessary to point to the logical flaws and to the empirical evidence to the contrary. Unfortunately, I hear the argument sufficiently often, I feel it incumbent on me to debunk it here.

First, when a borrower defaults on his outstanding debt, his ability to take on new debt and to service it improves. The only reason not to rush in and offer him your shillings immediately is the possibility that the past default provides evidence that increases the perceived likelihood of a future default. If the default was a pure ‘bad luck’ default, it would not do so. If the default is evidence of (unexpected) bad management by the borrower, new credit is less likely to be forthcoming. If the default is perceived as ‘discretionary’, that is, a case of ‘can pay but won’t pay’, credit is likely to be cut off.

Second, even sovereign debt defaulters have not suffered dramatically for their transgressions. Serial sovereign defaulters like Argentina tend to be back in the market after as little as three years. The Russian and Ukranian defaults of 1998 did not banish these countries to the Valley of the Financial Lepers for very long. Carmen Reinhard and Kenneth Rogoff have written two wonderful historical studies of sovereign defaults on external debt and on internal debt. I recommend both papers highly.

Even more relevant is the fact that, if the authorities adopt the good bank solution proposed by (among others) Paul Romer, Joseph Stiglitz, George Soros, Robert Hall and Susan Woodward and myself, it would be the legacy banks, stripped of their banking licenses and not engaging in any new lending or new investments, that would default on the unsecured debt. The new good bank (with just the (insured) deposits and the good assets of the original bank on its balance sheet in the version of the good bank model proposed by Hall and Woodward), could, until emotions and moods have settled, have its new unsecured debt guaranteed by the government. Rational would-be new unsecured creditors of the new good bank would in any case not be deterred by the bad experience of the old unsecured creditors of the bad bank. So there should be no problem attracting new unsecured creditors willing to lend to the banks.

Finally, a modicum of discouragement of new unsecured creditors is desirable. We don’t want to return to the reckless unsecured lending to banks of the past – lending that was highly instrumental in bringing us the crisis. Greater lender caution and prudence and a higher interest rate on unsecured lending to banks will be a positive and desirable feature of the landscape banks will have to operate in during the years to come.

Pensioners won’t spend

Default on unsecured debt, whether it takes the form of a write-down or write-off or (partial) conversion into equity will, through the pension funds and insurance companies holding these instruments, affect the consumption decisions of pensioners who find themselves with seriously diminished pensions and insurance policy holders whose policies have diminished in value.

I agree that this is what will happen. But what happens if instead the government bails out the unsecured creditors and makes the pensioners and insurance policy holders whole? The losses are still there and the government has to pay for them.

Consider the case where the government funds the secured creditor bail-out by raising taxes immediately. Unless there are important distributional asymmetries in the incidence of the tax increase under the bail-out scenario and the incidence of the losses suffered by the pensioners and insurance policy holders under the no bail-out scenario, the negative effects on demand should be about the same. If the unsecured creditor bail-out is financed by cutting public spending on goods and services immediately, the negative effect on demand is likely to be greater under the bail-out scenario than under the no-bail out scenario.

If the government borrows to fund the unsecured creditor bail-out, the bail out will be less contractionary than the no-bail out scenario, unless there is Ricardian equivalence (debt neutrality) – something I consider empirically untenable – or there is financial crowding out through an adverse asset market response to larger deficits. This could happen if the government has limited ‘fiscal spare capacity’ – its ability to commit itself credibly to future tax increases or public spending cuts is limited. In that case the government could still achieve a more expansionary effect from the bail-out scenario than from the no-bail-out scenario, if it were to monetise the debt incurred as a result of the bail-out. Of course, this monetisation could only be temporary if inflation is to be avoided when the economy returns to full employment.

More importantly, the government could prevent a decline in aggregate demand under the no-bail out scenario by a conventional Keynesian demand stimulus (tax cut or public spending increase), financed either by borrowing or by printing money. Even a balanced-budget increase in public expenditure on goods and services would be expansionary given a strict Keynesian multiplier.

So the third argument, that not bailing out the unsecured creditors would lead to a contraction of aggregate demand, may well be true but does not represent an argument for bailing out the unsecured creditors. The superior aggregate demand effects from bailing out the unsecured creditors by borrowing or printing money, compared to a policy of not bailing out the unsecured creditors exists only if the policy of not bailing out the unsecured creditors is accompanied by the government not doing anything on the fiscal side. The same demand-supporting effect achieved with the deficit-financed bail-out, can be achieved equally well by not bailing out the unsecured creditors and implementing a deficit-financed expansionary fiscal measure.

I conclude there are no valid arguments against forcing the unsecured creditors of bank and other financial institutions to sink or swim on their own, without any financial support from the state. Fairness considerations and moral hazard certainly support putting the unsecured creditors at risk. They made their bed; now they should lie in it


Don’t touch the unsecured creditors! Clobber the tax payer instead.

March 13, 2009

Good Bank vs Bad Bank

The Good Bank solution differs significantly from the Bad Bank solution as regards its distributional implications, its medium-term and long-term incentive effects and its immediate financial stability impact.

Under the Bad Bank approach, the authorities either purchase toxic assets from the banks that made the toxic investments/loans, or they guarantee (insure) these toxic assets. Toxic assets are assets whose fair value cannot be determined with any degree of accuracy. Clean assets are assets whose fair value can easily be determined. Clean assets can be good assets (assets whose fair value equals their notional or face value) or bad assets (assets whose fair value is below their notional or face value). When the authorities acquire the toxic assets outright, they establish a legal entity to manage these assets – the Bad Bank. The publicly-owned Bad Bank either sells these toxic assets as and when they cease to be toxic and a liquid market for them re-emerges, or holds them to maturity.

Under the Bad Bank approach, the legacy banks, either sans the toxic assets or with the toxic assets guaranteed by the state, live to fight another day. The presumption is that the state overpays for the toxic assets. The price it pays is certainly greater than the immediate liquidation value of the assets by their owners. It is also likely to exceed the present discounted value of the future cash flows of the assets, or their hold-to-maturity value. Similarly, the cost of any guarantees provided by the state in the case where the toxic assets continue to be held by the banks, is likely to be less than the fair value of these guarantees.

The rationalisation for the creation of Bad Banks and for toxic asset purchases by the state that was part of the original TARP proposal – it would serve as a price discovery mechanism for potentially socially useful financial instruments that had temporarily become illiquid – is no longer credible. Most of the toxic assets ought never to have been created and, with a bit of luck, will never be seen again. So the fundamental rationale for the creation of Bad Banks and for toxic asset purchases by the state is the provision of a subsidy to the banks that made the toxic loans and investments. These beneficiaries include the top management and board of these banks, the shareholders and the unsecured and non-guaranteed creditors.

The subsidies for the legacy banks inherent in the purchase by the state of the toxic assets and/or in the guarantees provided by the state for these toxic assets are further boosted by the myriad modalities of further official financial support for these banks. These can be additional capital injections, guarantees for new borrowing or guarantees for new loans and investments by the banks.

Under the Good Bank approach, the state creates a new bank, the Good Bank, which gets the deposits and the clean assets of the old banks. The old bank gets compensation equal to the difference between the (known) value of the clean assets it loses and the value of the deposits it gives up. The state may also inject additional public capital into the Good Bank, or it may invite in additional private capital. Government financial support is given only to new lending, new investment and new funding by the Good Bank. The legacy (ex-)bank has its banking license taken away and simply manages the existing stock of toxic assets. The legacy (ex-)bank does not get any further government support.

The Hall-Woodward-Bulow good bank solution

A particularly neat example of the Good Bank solution has been proposed by Robert E. Hall of Standford University and Susan Woodward of Sand Hill Econometrics. It can be found on the Vox website. They attribute the key idea to Jeremy Bulow. In what follows I merely adapt their numerical Citicorp example to the RBS Group.

The data for the Table below come from the Annual Report & Accounts 2008 of RBS. I am doing the exercise for the whole RBS Group. As it is unlikely that home country governments would be willing (or even able) to support the foreign subsidiaries of their banks, it might have been more appropriate just to consider the UK high-street banking units of the RBS Group. I leave that as an exercise for the reader.

Total equity of the RBS Group at the end of 2008 is reported on the balance sheet as just over £80bn. Market capitalisation is around £ 8bn. I therefore subtract £72 bn from the £2,402 total assets reported for the end of 2008, which leaves adjusted total assets at £2,330 bn. The tax payer has already put £45 bn into RBS. In addition, RBS has placed £325 bn of toxic assets in the government’s Asset Protection Scheme.

This means that RBS is a dead bank walking, a zombie bank, with its market capitalisation much less than past and present government financial support, let alone past present and anticipated future government financial support, which would also be reflected in today’s market capitalisation. I could have done the same type of exercise for Lloyds Banking Group, for Citicorp, for Bank of America or for UBS and many other zombie border-crossing banks.

Good Bank -Bad Bank
Deconstruction of RBS Group end-2008 Balance Sheet

(following the Hall-Woodward-Bulow approach) (£ bn)
RBS Good Bank Bad Bank
Clean assets
(good & bad) 1,012 1,012 –

Toxic assets 325 – 325

Derivatives 993 – 993

Equity in other bank – – 114

Total assets 2,330 1,012 1,432
Deposits 899 899 –

Debt securities &
other non-deposit 452 – 452

Derivatives 971 – 971

Total liabilities 2,322 899 1,424

Equity 8 114 8

Total liabilities
& equity 2,330 1,013 1,432

Capital ratio 0.34% 11.25% 0.56%

On the asset side of RBS group are clean assets (good and bad, but with known fair values) and toxic assets (assets with unknown fair values and derivatives. On the liability side, I distinguish deposits, debt securities and other non-deposit liabilities, and derivatives. In the US, the derivatives on both the asset and liability sides of the balance sheet would have been netted, which would have reduced the size of the balance sheet by almost one trillion pounds.

I assume that the £325 bn worth of toxic asset insurance offered by the authorities to RBS equals the stock of toxic assets on its balance sheet. This leaves RBS with just over £ 1 trillion worth of clean assets (and the derivatives, just under £1 trillion). ‘Deposits’ is shorthand for guaranteed or secured creditors. The £899 bn worth of deposits on the RBS balance sheet is, however, larger than what is formally covered by UK deposit insurance (or by the applicable deposit insurance schemes of the foreign subsidiaries). Debt securities and other non-deposit liabilities are claims on RBS by unsecured and non-guaranteed creditors. They include all unsecured debt, including subordinated debt, other junior debt and senior debt. RBS had £452 bn of this unsecured and non-guaranteed debt (plus of course some non-guaranteed and unsecured liabilities included in ‘deposits’). Then there is just under £1 trillion worth of derivatives on the liability side of the balance sheet.

Equity – market capitalisation – is a mere £ 8 billion, giving a capital ratio (equity as a percentage of assets) of 0.34%. Even with all the government support it has received, RBS group is effectively worth nothing.

The Hall-Woodward-Bulow Good Bank – Bad Bank deconstruction of the RBS balance sheet requires one key condition to hold: the value of the clean assets of RBS has to exceed that of its deposit liabilities. This will be more likely the larger the amount of non-deposit funding RBS engages in.

We split RBS into a Good Bank and a Bad Bank by giving the deposits and the clean assets of RBS to the Good Bank, leaving everything else with the Bad Bank, and giving the Bad Bank all the equity in the Good Bank. (The derivatives on both sides of the balance sheet could be given to the Good Bank instead of to the Bad Bank, assuming they are clean). Since the value of the clean assets (£1,012 bn) exceeds that of the deposits (£ 899 bn), the good bank has equity of £114 bn (mind the rounding errors!). Its capital ratio is a healthy 11.25%. If I had used a more restrictive definition of ‘deposits’, the capital ratio could easily have been over 20% or even 30%.

The Bad Bank keeps the toxic assets and derivatives of RBS. It also has the equity in the Good Bank as an asset on its balance sheet. On the liability side it has just the unsecured and non-guaranteed debt securities and other non-deposit liabilities. Its equity is, of course, the same as that of RBS: £8 bn. Its capital ratio will therefore be higher than that of RBS, because the balance sheet of the Bad Bank is smaller. Neither the equity owners of the Bad Bank nor the unsecured and non-guaranteed creditors of the Bad Bank are worse off than, respectively, the equity owners of RBS and the unsecured and non-guaranteed creditors of RBS.

To achieve the deconstruction/decomposition of RBS into a Good Bank and a Bad Bank according to the Hall-Woodward-Bulow principles would require that RBS be put into temporary administration. The new Special Resolution Regime (SRR) introduced for the UK in February 2009 provides the ideal legal setting for this. It should not take long, a weekend at most. Basically, the Bad Bank just becomes a financial portfolio of toxic assets and derivatives, plus its stake in the Good Bank. It would not be allowed to invest in any new assets or to engage in any banking activities. It would manage the existing asset portfolio down and would cease to exist once the last asset has been sold or has matured. Among the clean assets the Good Bank buys would be the buildings, equipment etc. necessary for conducting the banking operations of the Good Bank.

If the UK government had not been daft enough to guarantee the £325bn worth of toxic assets on the balance sheet of the Bad Bank, there can be little doubt that the Bad Bank I have just constructed would have failed soon after coming out of the SRR. The Bad Bank, which is just a fund restricted not to invest in new assets, would be put into administration. The shareholders would be wiped out (more than 70 percent of RBS is now government-owned), and the unsecured and non-guaranteed creditors would determine what to do with the Bad Bank and its assets. Most likely there would be a significant debt-to-equity conversion and/or a large write-down of the debt.

The government would focus its financial support on the Good Bank, either by providing it with additional capital or by guaranteeing new lending and/or new borrowing by the Good Bank. Private capital could be attracted into the Good Bank too.

Distributional differences between the Good Bank and the Bad Bank solution

The Good Bank solution favours the tax payer. The Bad Bank solution favours the unsecured and non-guaranteed creditors of the zombie banks. ‘Tax payer’ includes those beneficiaries of public spending programmes that may have to be cut to meet the fiscal cost of purchasing or guaranteeing the toxic assets under the Bad Bank solution. It also includes those who lose as a result of future inflation or sovereign default, should either of these two solutions to dealing with the public debt created as a result of the Bad Bank solution eventually be adopted.

The Bad Bank solution also favours the shareholders of the zombie banks, but in the case of RBS, this is mainly the government and therefore the taxpayers. The amount of shareholder equity involved in the zombie banks is, in any case, negligible compared to the exposure of the unsecured and non-guaranteed creditors. The Bad Bank solution also saves the jobs and perks of the top management and the boards of the zombie banks – often the very people responsible for turning a once-healthy bank into a zombie bank.

There can be no doubt that, from a distributional fairness perspective, the Good Bank solution beats the Bad Bank solution hands down.

Incentive effects of the Good Bank and the Bad Bank Solution.

The Bad Bank solution creates moral hazard, because it rewards past reckless investment and lending. It also represents an inefficient use of public funds in stimulating new lending by the banks. To stimulate new lending, a subsidy to or guarantee of new lending is more cost efficient than the ex-post insurance of losses that have already been made on old lending, even though their true magnitude is not yet known. The Good Bank solution leaves the toxic waste with those who invested in it and with those who funded these activities, freeing government funds for reducing the marginal cost of new lending or increasing the expected return to new lending.

Both as regards moral hazard (incentives for excessive future risk taking) and as regards the efficient use of government funds (’new lending bang per buck’), the Good Bank solution beats the Bad Bank solution hands down.

Financial stability implications of the Good Bank and Bad Bank solutions: saving banking, without saving bankers or the existing banks

The holders of bank debt, with the possible exception of perpetual subordinated debt (which counts as tier one capital in some countries), have become the sacred cows of this financial crisis. Regulators, central bankers and Treasury ministers are quite willing to see shareholders wiped out. After the demise of WAMU and Lehman Brothers, however, the unsecured creditors have become inviolable. Somehow, those in charge of macro-prudential stability, notably the Fed, have bought into the notion that if there is either a further default on bank debt, or a restructuring involving a significant debt-to-equity conversion, or a signficant write-down of the claims of bank bond holders, this will be the end of the world.

I just don’t buy it. Fortunately, I am not the only one. Luigi Zingales, the Robert C. McCormack Professor of Entrepreneurship and Finance at the Chicago Business School, has been advocating the case for mandatory debt-into-equity conversions, debt forgiveness and other up-tempo Chapter 11- style financial restructuring of banks and other defunct behemoths like GM, since the first days of the crisis (see e.g. (1) and his book Saving Capitalism from the Capitalists, co-authored with Raghuram Rajan). Robert Hall and Susan Woodward also feel no need to pay any special attention to or lavish any public funds on the toxic assets, their owners and those who funded them (the unsecured and non-guaranteed creditors) once the Good Bank has been established and sent on its way.

Part of the reason there appears to be this widespread belief that you have to guarantee all bank liabilities is that this is what the Swedish authorities did during their 1991-1993 banking crisis (see e.g. Lans Jonung’s paper “The Swedish model for resolving the banking crisis of 1991-93. Seven reasons why it was successful” . First, Jonung lists seven criteria for ’successful’ resolution of a banking crisis. The paper does not demonstrate that this septet constitutes a set of necessary and sufficient conditions for success – if indeed the Swedish approach is deemed to have been a success. Second, success is in the eyes of the beholder. The Swedish banking system has been hard hit again in the current crisis by its overexposure (30 percent of annual GDP) to risky investments in Central and Eastern Europe, including the Baltics and Ukraine.

Every financial boom/bubble has been characterised by rising and ultimately excessive banking sector leverage, that is, by excessive lending to banks. If all the unsecured creditors of the banking system were made whole in the previous systemic crisis, it is not really surprising that the banks, and their creditors, are back for more.

In a more systematic study of the use of blanket guarantees of bank liabilitiesLuc Laeven and Fabian Valencia find the following:

“Using a sample of 42 episodes of banking crises, this paper finds that blanket guarantees are successful in reducing liquidity pressures on banks arising from deposit withdrawals. However, banks’ foreign liabilities appear virtually irresponsive to blanket guarantees. Furthermore, guarantees tend to be fiscally costly, though this positive association arises in large part because guarantees tend to be employed in conjunction with extensive liquidity support and when crises are severe.”

The proposition that the consequences of inflicting losses on holders of bank debt are awful beyond our wildest imagining is voiced incessantly and loudly by bankers and by those long bank debt, especially insurance companies and pension funds. And a vigorous campaign is underway to extend the no-default presumption to the debt of pseudo-banks like AIG.

The most over-the-top, ludicrous piece of attempted scare mongering about the systemic risk implications of default by any institution I have ever read is the internal memorandum “AIG: Is the Risk Systemic”, of 26 February 2009, which is now all over the internet. Just one small sample: “The failure of AIG would cause turmoil in the U.S. economy and global markets , and have multiple and potentially catastrophic unforeseen consequences“.

I would have thought that, on the contrary, markets have discounted the likelihood of default by many of the major border-crossing banks, and by AIG, pretty comprehensively by now. After the US authorities bailed out Bear Stearns in March 2008, letting Lehman go belly-up in September 2008 was a bad surprise. Even then, I don’t accept the interpretation that it was Lehman’s filing for bankruptcy protection that triggered the cardiac arrest in global financial markets in the second half of September 2008. Instead the financial sector convulsions of the last quarter of 2008 were caused by the realisation that (1) most of the US and European border-crossing banks were insolvent without government financial support, that (2) the rot extended to the shadow banking sector (AIG), and that (3) the US authorities (Treasury, Fed, SEC) were not on top of the issue and that Congress was bound to act irresponsibly.

But even if it had been Lehman that triggered the financial upheaval, that was then. This is now. Banks, counterparties, investors and policy makers have had 6 months to adjust to the new reality and prepare for the eventuality of default on zombie bank debt and even on AIG debt. The bonds of large zombie banks trade at spreads over government yields comparable to those of automobile manufacturers (600 – 650 basis points). Their CDS spreads put many of these banks well into the default danger zone. Their stock market valuations are consistent with those of institutions not a mile away from insolvency and default.

The fact that zombie banks or AIG are self-serving when they plead systemic risk as an argument for further government hand-outs does not mean that they are wrong. It does lead one to verify more carefully the logic of their arguments and the quality of the empirical evidence offered in support. Let me just consider the argument that the main investors in bank debt (and AIG debt) – pension funds and insurance companies – are too vulnerable and too systemically important to permit the banks (or AIG) to fail.

Pension funds don’t go broke with adverse effects on systemic stability. If they are funded, defined-contribution funds, a reduction in their asset value means that pensioners will get lower pensions. If they are defined-benefit schemes (including ‘final salary schemes’), the risk of investment surprises is shared by the sponsors and the beneficiaries. When the Dutch pension fund ABP took a big hit last year, my parents did not get any indexation of their pension benefit. In past years, pension benefits had tracked earnings inflation, and occasionally price inflation. Should coverage ratios decline enough, even nominal cuts in pension benefits can be implemented. This may cause hardship, but not financial instability. No reason to favour the pensioners over the tax payers.

As regards insurance companies, I doubt whether “Insurance is the oxygen of the free enteprise system”, as AIG would like us to believe. Certainly insurance companies like AIG are not the only suppliers of oxygen. Insurance is a regulated industry. Orderly restructuring following administration and insolvency need not interfere with the provision of any of the essential infrastructure services required for the proper functioning of a market economy.

Regulators, especially but not just in the US, have bought the ‘don’t touch the unsecured creditors’ argument. The Fed especially appears to have swallowed it hook, line and sinker. This cognitive regulatory capture has turned the Fed, with the enthusiastic support of the FDIC and the US Treasury, into the most powerful moral hazard propagation machine ever.

If a bank or an insurance company like AIG is at risk of failing but is truly too big or too interconnected to fail (rather than merely too politically connected to fail), and if a Good Bank solution is not feasible, then the institution in question should immediately be taken into public ownership or put into a special resolution regime, if one is available. From public ownership it can be put into administration. Once in administration or under a Special Resolution Regime, it can be restructured decisively through a mandatory debt-to-equity conversion or debt write-down. There is no case for sparing the unsecured creditors.

⁂ European Central Bank capitulating in face of crisis

Two similar articles from newspapers on the political Right and Left forwarded for your information by Anthony Coughlan:

Tuesday 24.2.09

ECB faces mutiny from national bank governors as recession deepens
– The European Central Bank is capitulating.

By Ambrose Evans-Pritchard

For months the ECB held sternly to the high ground of orthodoxy as the US, Japanese, British, Canadian, Swiss and Swedish central banks slashed rates towards zero and embraced quantitative easing, but a confluence of fast-moving events is now forcing it to move.

The credit default swaps that measure bankruptcy risk on the debts of Ireland, Austria and a clutch of Latin Bloc states have vaulted to dangerous levels. In the case of Ireland, the slump is spilling on to the streets. Some 120,000 marched through Dublin over the weekend to protest austerity measures.

The slow fuse on Eastern Europe’s banking crisis has detonated, leaving Austrian, Belgian, Italian and other West European banks with $1.5 trillion (£1 trillion) in exposure.

It is happening just as industrial output collapses in the eurozone’s core states. Germany’s economy contracted at 8.4pc annualised in the fourth quarter. ECB president Jean-Claude Trichet said on Monday that “a process of negative feedback” has set in where the banks and the real economy are pulling each other down in a self-reinforcing spiral. Eurozone credit is contracting. Banks are rationing credit as deleveraging gathers pace.

Rob Carnell, global strategist at ING, said the ECB has been painfully slow to acknowledge the global deflation tsunami sweeping across Europe.

“It seems divorced from reality. It is clearly nonsense to talk about inflation now: it has been negative on average for six months. The eurozone purchasing managers’ index has fallen twice as fast as in the US, so the ECB should be acting even faster than the Fed,” he said.

Mr Trichet said the ECB has increased its balance sheet by ¤600bn (£525bn) since the Lehman collapse in September. The bank is providing “unlimited liquidity” in exchange for a wide range of collateral, including mortgage bonds issued for the sole purpose of extracting ECB funds.

But the ECB’s leading voices have adamantly refused to contemplate going to the next stage: buying bonds and other assets with “printed money”. They see that as the Primrose path to hell. This week the tone has abruptly changed, suggesting that a majority of the 16 national bank governors on the ECB council are having second thoughts.

The apparent ring-leader is Cypriot member Anastasios Orphanides, a former Fed official and a world authority on deflation traps. He said on Monday that the ECB may have to go beyond “zero-bound” rates and revealed that an “internal discussion” was under way.

Italy’s Mario Draghi is in the “activist-easing” camp. “The experience in the US in the 1930s and Japan in the 1990s suggests that it is necessary to fight, in the early phases of the crisis, the tendency for real interest rates to rise,” he said.

Finland’s Erkki Liikanen is of the same opinion. “We are facing the worst financial crisis in our time. It is important not to exclude, ex ante, any measures.”

Julian Callow from Barclays Capital said 10 ECB governors are now doves.

This amounts to a mutiny against the Bundesbank-dominated executive in Frankurt. It is no great surprise. They have to answer to their democracies. The plot is thickening.

The Euro, an Illusory Shield against the Crisis ?

L’Humanite, Paris , Thursday 19 February 2009,

by Isabelle Metral (Translated)

Most political leaders of euro-zone countries make it sound as though the single currency has shown its capacity to play a protective role as the financial crisis sweeps across the Old Continent. So much so that today, even the staunchest of the Euro-sceptics (the British, Icelanders, Swedes, or Danes) are supposed to have suddenly realized the advantages of joining the euro…

The claim was made by Joaquin Almunia, European commissioner for economic and monetary affairs, on Tuesday last.

The EU leader’s statement actually betrays a growing concern in the face of signals showing increasing divergences between the different regions or countries of the euro zone. These divergences might eventually lead some countries to consider opting out of the single currency.

The crisis shows up the very serious defects in the original conception of the euro.

Entirely obsessed as they were with the stability criteria put forward by financial markets, those that championed its creation in 1999 were aiming first at a “strong euro” in the hope of luring as much capital as possible to the European market.

Hence the curb on public spending (with the Maastricht treaty), the pressure on wages through the deregulation of labour markets that diminished labour’s negotiating power. “The euro has brought war over exchange rates to an end, but it has exacerbated competition over prices,” rightly claimed Jean-Paul Fitoussi, president of the Observatoire français des conjonctures économiques

Today, the deepening crisis and the effect of the competition between states that sink deeper and deeper into debt have the additional effect – a refinement on the earlier stages – of bringing the pressure of competition to bear on the States’ capacity to meet their debts (in treasury bonds).

Indeed, if euro zone countries are united by the single currency and the European Central Bank, the rates at which they get loans, and the conditions attached to them, vary from one country to the next. Before the crisis, the spreads remained quite limited. But with the plunge into recession, and the gigantic assistance granted by the various states through bank bail-outs or economic stimulus plans, this is no longer true.

Spain and Ireland, for instance, which until a short time ago, were still praised as models of economic success by pro-marketers in Brussels and elsewhere, are now going through a period of fierce turbulence. As a result, they are at a disadvantage on financial markets and find it difficult to raise money.

Sovereign loans in the euro- one consequently tend to be widely spread. The risk premiums demanded from the frailest countries are soaring, unlike those demanded of Germany, which is still considered an exemplary borrower. The benchmark rate for German (Bund) loans over 10 years last Monday stood at 2.98%, much lower than that of France (3.50%), or of Spain (4.13%) or, above all, of Greece (5.47%).

The over-rated credit rating agencies were not slow in down-grading Madrid and Athens. Downgrading a state amounts to casting suspicion on its ability to pay back its debts as settled, in the best conditions.

In such circumstances, some countries that are strangled by the service of an increasingly heavy debt might be tempted simply to leave the euro ship. To ease the stranglehold, they might try devaluing their restored national currency as a last resource, in order to boost their exports.

This prospect has made the fortune of the managers of the Intrade site where, for the last few months, it has been possible to bet on one or several of the sixteen euro-zone countries opting out of the euro. The contract expires at the end of 2010.

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