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How will a capitalization plan actually work?
I'm all for bank capitalization but the problem is this: the Fed has been lending hundreds of billions to banks for many moons. Right now the banks are just sitting on the money, for the most part.
To be sure, Treasury equity is not the same as debt to the Fed, but are they so different? Keep in mind the Fed has been a softie to A.I.G. ($30 billion more), so the Fed is hardly a loan shark and in some ways the Fed's I-can't-just-stop-rolling-it-over-when-I-want contribution is a bit like preferred equity.
To put it another way, will partial government ownership so much change bank incentives for the better?
Which is it?
1. Treasury capitalization will matter to the extent that Treasury equity has some different properties than from-the-Fed debt, but this isn't nearly as much of an effect as any published sum for a Treasury capital inflow would indicate.
2. Treasury equity will work because of some legal or regulatory difference between equity and debt which we are otherwise unwilling to abolish.
3. Treasury equity will work because it is a hidden giveaway to bad banks (by the way, this is arguably what happened in Sweden). But of course we could do the giveaway more directly if not for bad PR.
Inquiring minds wish to know.
Three other points:
4. Capitalization might have a bigger marginal oomph in Europe than here, because the ECB hasn't been going crazy lending out reserves as the Fed has.
5. If the key is to get banks up and running again, we want bank CEO contracts with lots of bonus compensation on the profit upside and those contracts are more important the "worse" is the bank. Ouch.
6. If such a plan will raise the value of lots of banks, by a lot, none of the shareholders will wish to sell early at low prices, a'la Grossman and Hart 1980, and the Treasury will be back in a bind.
That is what Alex and I talked about over dinner. I conclude that the crisis will not end anytime soon.
Posted by Tyler Cowen on October 10, 2008 at 02:55 AM in Economics | Permalink
Comments
Everyone keeps talking about re-capitalizing banks but can someone take the time to explain what that actually entails? When a bank is building up capital, what exactly are the nuts and bolts of what they are doing? I looked up what capital was but can someone explain how a bank would go about raising their "wealth, whether in money or property, owned or employed in business by an individual, firm, corporation, etcetera.?"
Posted by: sohaib at Oct 10, 2008 4:43:08 AM
I'd say a combination of 1 and 2.
There is a big difference between debt and equity funding -- the effects on capitalization ratios. One of the big problems is that most banks have taken (or will need to take in their next published financial statements) big losses, which push their capitalization rates below the legal minimum. Once this happens, there are only three straightforward ways to return to compliance:
a) profits combined with dividend cuts. The first is going to be down if not negative through 2010; dividend cuts should be mandated but are too small to make a material difference
b) raise capital from investors. Some banks (Goldman Sachs) have been able to do this privately, but others are having problems (Morgan Stanley)
c) reduce assets, i.e. lending
If capital ratios are indeed the constraint on lending, the only way to get banks to lend is to increase capital. Treasury debt provides funds, but the banks can't make new loans when they are capital constrained. If private investors are too scared (and I don't blame them) then the only hope is government investors.
Note there are three other proposals which would relieve the capital constraint. The first is for TARP to overpay for assets, thus giving banks profits. This would be a big giveaway to existing bank shareholders and management, and subject to lots of problems in execution. The second is to suspend mark-to-market and thereby pretend that losses haven't occurred, and thus capital ratios are just fine. This would provide the most relief for, and thus encourage the most new lending by, those banks which have made the most bad investments / loans. Finally, we could relax capital ratio requirements.
Between relaxing capital requirements and government investment in equity, I prefer the latter as it provides some upside for the taxpayers, who are going to be paying lots under every plan listed.
Posted by: Marc in Asia at Oct 10, 2008 5:11:07 AM
"....so the Fed is hardly a loan shark"
read the terms of the AIG oan
set up fee 2%
fee on UNdrawn balance: 850 bp
fee on drawn balance: libor+850
Posted by: jck at Oct 10, 2008 5:35:00 AM
#5 is a good point -- why risk your bank by making loans, when your bonus will likely be capped by the govt, and you'll be prosecuted for fraud after a bankruptcy? The human instinct for punishment is not conducive to economic growth. We should go back to the pre-Enron prohibition on debtor's prison.
Posted by: DK at Oct 10, 2008 7:18:27 AM
BANK. Get it?
Posted by: josh at Oct 10, 2008 9:56:01 AM
Treasury "equity" is just debt, too, Tyler.
Posted by: Yancey Ward at Oct 10, 2008 11:51:17 AM
As a layperson, it seems there are two different problems.
1) Ensuring that bank depositors get their money back. This is accomplished by FDIC insurance, and perhaps other limited measures.
2) Getting the banks lending again. Giving banks money (whether through equity, debt, or simply giving it away) does not automatically create lending. The quesion is who will the banks lend TO: GM, individuals at risk of losing their jobs, small businesses in an economy spiraling downwards? You can be sure that the banks arent willing to bet on promises as before, they will want proof of an ability to pay, either through profits/income or from assets (ie equity or reserves.) With so many of us (individuals and business alike) either loaded up on debt, or reliant on credit to survive, few will be able to meet these requirements. So the money will just sit there in the bank vault (or T bills), and we will have spent billions with no impact.
Posted by: newbie at Oct 10, 2008 2:09:51 PM
I don't understand the argument for relaxed capital requirements or suspending mark-to-market, which are pretty much the same thing. Doesn't that lead to excess leverage, and isn't that part of what got us here? So wouldn't doing that just lead to more implicit guarantees and bailouts? IMO honest accounting does a lot to prevent, or at least limit, financiial disasters.
As for CEO compensation, incentives are fine, but for new CEO's. Why give someone who made a mess a big reward for cleaning it up? And yes, let's have some caps, or maybe just a fairly concave compensation package. These guys are supposed to be bankers, after all, not VC investors.
Posted by: Bernard Yomtov at Oct 11, 2008 5:32:49 PM
