ONE of the big lessons from economic history is that banking crises mustn’t be left to fester. If a country suffers a financial implosion, it is important to act fast to clear up the mess and to ensure the credit system returns to normality quickly. The last thing anybody needs is zombie banks kept alive through inertia or cheap money, taking years to recover and dragging down the economy, Japan-style.
Iceland, the US and Sweden have all shown how this can be done, though all three models were imperfect. Iceland allowed banks to go bust, defaulted on its debt, reneged on international deals and wiped away bad debt at an astonishingly fast rate. The US introduced the Troubled Asset Relief Program (Tarp), purchasing dodgy assets from the biggest financial institutions, in return for equity warrants and controls on pay. The US also purged a vast amount of bad debt in other ways, some good and some bad (far too many people just walked away from mortgages, for example, storing up huge problems for the future). The Swedish solution in 1991-92 involved the state taking on bad debt, with financial institutions being partly nationalised and shareholders heavily or totally diluted.
All three of these models purged bad debt; all had big disadvantages: Tarp, for example, caused moral hazard and subsidised bondholders.
There are better ways of purging banking systems than either of the methods chosen by those three nations. The best way to deal with future banking crises would be to harness market mechanisms, using new resolution mechanisms to bail-in banks, handing them over to bondholders by converting their IOUs into fresh equity. Boards would be fired, expensive staff contracts suspended. Dodgy loans would be written off very quickly. The devil is in the detail, obviously, and it is crucially important to build a workable special banking bankruptcy code to ensure a smooth transition, the protection of taxpayers (and thus drastically reducing moral hazard) and the protection of depositors (but with careful provisions to make sure they have a greater incentive to monitor riskiness).
It is clear that the UK’s response to its banking crisis was substantially worse than several other countries’. Policy was confused and half-hearted. But King’s outburst yesterday, when he dismissed RBS’s restructuring to date, called for its total nationalisation and split into a good and bad bank, was unfair, at best several years out of date and a partial assessment of Britain’s current problems.
Hidden bad debt on (some) bank balance sheets is a problem, though there is no reliable estimate of its extent. But to me the far greater issue is that a lot of what looks like viable debt today wouldn’t be if interest rates were to go up to proper levels. The real zombie firms and households are those that couldn’t cope with interest rates at 5-6 per cent or higher; banks cannot pull the plug now as they are currently viable, but they understandably realise that there will be trouble ahead and are therefore being cautious. It is also clear the government would not have tolerated a much more activist policy of repossessions had the banks wanted to go down that road.
Ultimately, the biggest reason why banks have not liquidated more bad loans is that monetary policy is too loose. King’s own actions have ensured the system remains clogged up – while his support for sharply higher capital and liquidity requirements in a downturn has also throttled credit. It will be fascinating to see how Mark Carney, King’s eminently sensible successor, handles this issue when he takes over in July.
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