If the banks need any more public money, the government should buy high street branch networks and create (and then slowly privatise) a 'good bank'

The most straightforward way to solve the current crisis is bank nationalisation. There are a few reasons why the government might not want to take this path, one of which is the large overseas assets and liability of UK-based banks. The sovereign has limited fiscal credibility; the key to avoiding future hyperinflation is not biting off more than it can chew. It should focus on the UK and on creating a 'good bank' to promote future lending.

I never suggested that the government buy stakes in banks, as the UK government did late last year. However, in retrospect it seems to have been a good plan. The systemic collapse of the banking system was forestalled.

Of course, most of that money went into a black hole. But the government did end up by owning large parts of the banks' equity, which might be worth a lot in the future if the banks recover. £37 billion for pure upside on say £2trillion of assets isn't too bad a deal. And having an equity stake is clearly not the same as guranteeing the banks liabilities for free. Limited liability still applies.  

However, the government obviously has certain responsibilities in the UK banking system - it needs to guarantee the deposits of UK savers, and it needs the banks to lend enough to keep the economy going.

To summarise, the UK government has two clear requirements, both UK based
a) 'Get lending going again' to UK individuals and companies
b) Guarantee the deposits of UK individuals, charities and (probably) companies

These objectives can be acheived by a transaction that involves:
a) Buying the branch networks of the major UK banks (needed to 'get lending going') 
b) At the same time, taking on the liabilities of the domestic depositors
c) Taking on the 'good' assets in the corporate lending and mortgage book

The old banks would be left with more cash (from being able to sell some of their tangible assets). This would leave a deleveraged, cash-rich rump (including in effect an overseas lending unit) which might die slowly.

HBOS would be a good example. The government should take on the branch network, and the brand and the domestic depositors (liabilities), and the good parts of the domestic mortgage book (assets); but none of the 'toxic debt'. This would then be a 'good bank'.

The government could then progressively sell stakes in the 'good bank' to private investors.

The main risk for this plan, would be that if only some of the branch networks were bought, there might be a run on the other, privately owned banks. 

There would still remain the question of what to do with the remaining 'bad bank'. Few might lend to it; but in any case few are lending to the big banks now anyway. Bankruptcy is one option, but it usually involves plenty of money for lawyers.

If the banks are insolvent, they need to be declared bankrupt. Bankruptcy has risks; the main one being the huge 'costs of financial distress' (Lehman Brothers will keep its' liquidatorsarmy of lawyers and accountants busy for many years) the advantage of the government buying the 'good bank' first, is that systemically important assets (uk depositors, interbank lending) can be trasferred into the public sector first.

New lending must be seperated from existing lending. Current government thinking suggests that we need a government-backed good bank much more than we need a government-owned bad bank. And taking on the bad assets is socialising private risks - not a good idea. Better to create the good bank first, including both high-street and capital-markets elements. Use the good bank to get lending going and to 'look to the future'. The remaining bad bank would be cash rich with a more volatile and non-domestic balance sheet and fewer tangible assets. It would have in effect a skeleton team remaining. If insolvent it would wind itself up naturally.

9 comments:

Anton Howes said...

Downside to good bank/bad bank is still government involvement.
It's alright to say that they'd privatise it gradually, but this is still a huge risk, if not the biggest.
Again, there's the problem of valuing and assessing which assets are toxic or not (part of where all the uncertainty and lack of confidence is I believe).

Debt-for-Equity swaps however (yes, I'm a fan of them) require no taxpayer involvement, address the problem of valuation (the new shares rise with an undervaluation of "good assets" - presuming that you purposefully overvalue toxic assets in order to be on the safe side), and won't result in the "baggage" of toxic assets as they're simply written off instead of left in a bad bank. Only downside is that it devalues the shares of existing shareholders.

TheClimatePhilosopher said...

Debt-for-equity swaps are a way of dealing with the existing (bad?) banks. I think they are the natural way to deal with them, although some details may need to be worked out (which debt is swapped for equity - clearly not domestic deposits - where do you draw the line?)

Debt for Equity swaps are not necessarily the solution for 'getting the banks lending again'. They don't necessarily deal with the inherent problem of pro-cyclicality in bank capital requirements. The banks would still be 'bad', containing lots of 'bad' (e.g. US subprime) and 'perishable' assets (e.g. UK mortgages) and would hobble on, risk-averse for some time.

I'm not necessarily proposing the traditional good bad/bad bank model (which is really nationalisation).

Thanks for the comment about asset values. Good assets are much easier to value than bad ones.

I'm suggesting we need a new *good bank* (or banks), without dealing with the bad assets (they should stay where they are; swapping debt for equity would be fine to deal with the old banks).

Instead of recapitalising the bad banks, the government should create and recapitalise some new good banks. This would be done at arms length, by an independent agency. The new good bank(s) could be privatised quickly.

TheClimatePhilosopher said...

Anton's Work on Debt for Equity Swaps is available here:
http://tinyurl.com/d6mxl6

Reply From Anton

Yeah, you're right about choosing which debt is replaced. The implication when Debt-for-Equity is carried out is that not only is debt eliminated, freeing up available capital reserves to replace or phase out bad assets, but if large enough means that the bad assets can simply be written off and thus abandoned. The way I see it, if the swap is big enough, all toxic assets can be simply written off. The bank is then left with reduced debts, as well as reduced assets.



Did you read my blog posts? I think in a sense I may have assumed the extra step - the swap is one thing, but during the swap, bad assets and toxic mortgage receivables have to be written off completely. Then overestimating it would mean that the shares would increase in value. Sure, they'd still have risk associated with some assets, but then that's the nature of them - at least the unpayable ones would have been written off.

I agree it's not the only step to encourage lending. I think it's step 1 however - once toxic assets have been stripped out, afforded by the replacement of debt for equity, and there is available capital for banks to lend comfortably, it's then a matter of boosting their confidence (or in the way we've done it, to tax excess capital not devoted to boosting the volume of lending). That is the measure that gets rid of pro-cyclicality I think, as well as the stringency of regulation varying to be counter-cyclical.

In terms of what you've been suggesting, I guess it's a bit like having the "good bank" but simply not having a "bad bank" - the bad assets are just discarded or abandoned. Existing capital then no longer needs to be used to cover toxic assets, as they no longer exist. It means the bank is effectively deleveraged overnight.

Tim Joslin said...

"Limited liability still applies."

Really? This is the problem with Government involvement in the banks. The trick they need to pull off is to convince the markets that they're like any other shareholder and have only limited liability whereas in fact we all know that at the end of the day they underwrite the banking system. This ambiguity is necessary on the one hand because allowing the bankruptcy of one of these institutions is simply insane - a point unfortunately forgotten on September 15th - and on the other the forex and Treasury markets would take fright if the UK taxpayer was (on top of its already stretched fiscal position) formally liable for the one or more of the 5 largest balance-sheets on the planet.

The value of bank assets is indeterminate. Furthermore, if allowed to realise losses over a long period of time as profits are made on other existing and new business, they need never report an operating loss. Whether they are "solvent" or not is entirely moot. The Government should therefore continue to do what I believe it is now doing, i.e. support the banks in insisting they are sufficiently capitalised (fudging mark to market if necessary), and take any further pragmatic steps necessary to muddle through.

The problem with interventions such as setting up "good banks" etc etc is that you never fix the underlying problems in the banking system and economy generally. Nationalisation is by far the worst option (IMHO the Government has gone too far already - e.g. see http://unchartedterritory.wordpress.com/2008/10/22/the-mother-of-all-stealth-taxes/ ) as you create the next banking crisis. Increasing the political risk of nationalisation means that, next time, share-holders will pre-empt the expropriation of their assets. A "take the money and run" attitude to investing in bank stocks is not something to be encouraged - but that's exactly what the UK Government is doing. Note that the Swedish banks, the result of the supposedly brilliant model we're all following, simply repeated their mistakes by lending in the Baltic states. House prices in Riga exceeding those in Berlin, but keep writing those mortgages, eh!

Robin Smith said...

This is a nice analysis, I don't claim to understand all the terminology used. One thing stands out for me:

Why does "Anyone" need to guarantee depositors money?

I'll tell you. Because the depositor money is not linked with real wealth. It is linked with real wealth + transfers of wealth (land titles, other money creation investment activity!!! and other monopoly rights that have produced no change in the common stock of wealth)

Do you all accept that my assertion is possible? If so I'd like to propose the following:

Any new money put into circulation is based on tangible wealth, not monopoly wealth transfer rights. Such a thing could be a common basket of goods, reassessed on a regular basis and fine grained enough not to be affected significantly by acts of God. (this work has been doen already)

How about it? I beg you not to tell me that monopoly rights to other peoples wealth are fine and should be allowed to continue...

TheClimatePhilosopher said...

@Robin
Thanks for your comment; very interesting. The basic point to link this with your article is to argue that these banks can perform a banking function (lack of capital in banking system and lack of money in non-banking system) as well as rebuild infrastructure.

Your point is good. I'm not going to address them directly now, since it is out of my scope for today. Brief thoughts (rather imperfect due to this being work time).

I'd like to see the evidence of a shortage of cash in the real economy (even though I argue that this is the case).

Solutions exist that don't involve turning the banking system upside down; although we may want to do just that; that's a bigger issue.

Abolishing debt finance might actually make financing tackling climate change harder, although it might be good for the planet in the long run.

Robin Smith said...

Steve, I'll await your comments we can discuss next week. Just spoke to Neale about coming up.

On climate change, you know my assertion is that it will be inevitable if we continue to allow the private collection of RENT. RENT gives employees and employees no option but to use the cheapest kind of energy, lest they risk impoverishment. Any other mitigation activities are merely nice but wasted palliatives. See here:

http://gco2e.blogspot.com/2009/07/rent-climate-change.html

TheClimatePhilosopher said...

See here for followup

Robin Smith said...

I just had another thought. Banking employees are the private sector analogue of the public sector employee dead weight costs.

Money costs almost zero to make and very littel to manage. Yet they claim most of their profits in interest go to wages!!!

That is a huge waste. Its a socialist policy to pay people wages the economy does not need to function. Its a destruction of wealth to pay people for non productive work when they could be doing something useful. I'll blog that in a mo.