Forget Saving Doomed Banks: Start New Ones


If we are going to spend the remaining TARP funds to rescue the banking system, why not do it by capitalising new banks and letting the old ones go the way of all things: into oblivion? That’s the proposal of Paul Romer, a senior fellow at the Stanford Institute for Economic Policy Research.

Of course, the doomed banks will lobby like mad to make sure that this never happens. Still, it’s refreshing to hear someone argue against our economically suicidal policy of pouring good money into bad banks, perpetuating our on going Night of the Financially Dead.

Here’s Romer from today’s WSJ edit page:

If the TARP funds go to existing banks, much of them will end up stuck in financial institutions that are still bad after the transfer. We know from the previous round of TARP that giving more capital to bad banks generates very little net new lending.

Proposals for turning existing banks into good banks — recapitalizing them, nationalizing them, transferring the toxic assets off their balance sheets, or insuring the toxic assets — require prices for all these hard-to-value assets or, worse still, prices for derivative contracts on the toxic assets. (Calling the derivatives “insurance” doesn’t make them any easier to price.) Without reliable market prices for the hard-to-value assets, any proposal for turning bad banks into good banks could lead to huge transfers of wealth between taxpayers and bank shareholders.

If the government lets new banks provide the new lending that the economy needs, it could return to clearly stated and familiar policies for bank regulation. The government could announce that it will not invest any new capital in a troubled bank that it hasn’t yet taken over. Nor will it offer troubled banks any transfers or implicit subsidies. It can stick to a policy of assigning accurate values to assets as new information comes in. It can follow the usual FDIC procedures for protecting depositors and taxpayers and for deciding when to take over a distressed bank, and managing careful workouts that avoid the turmoil that a Lehman-style bankruptcy proceeding can cause.

No recapitalization. No insurance. No troubled asset purchases. Just take over the failures and liquidate them. Reserve the new money for new banks. It’s definitely better than what we’ve been doing.  And once capitalised with seed money from the government, new private capital might begin to return to banking.

The biggest danger in this idea is that its far from clear we can trust the government to responsibly capitalise new banks. The government lacks access to market processes that allow for entrepreneurial decision making. So it might wind up screwing up even this plan.