The latest bank rescue idea is getting criticised in all the usual places. This morning the New York Times reported that the Obama administration is considering converting TARP preferred shares to common equity. Paul Krugman, who has been a leading critic of the Bush-Obama bailout moves, thinks the move is just “shuffling-deck-chairs” on the Titantic.
According to Krugman, the move to reclassify the shares does nothing to improve bank capital. Senior creditors should be indifferent to whether shares are preferred or common, since both are junior to debt.
“So from the point of view of the creditors, capital includes preferred shares as well as common equity. Or to put it a bit more generally, from a creditor’s point of view capital is everything that has a more junior claim than you do,” Krugman writes. “But in that case, converting preferred into common does nothing: it’s just a swap among the junior stuff, with no impact further up the line. It’s certainly not a fresh infusion of capital in any meaningful sense.”
University of Louisiana at Lafayette professor Linus Wilson thinks Krugman is overlooking something very important: The incentives on bank managers themselves. While senior creditors may not care whether the shares are preferred or common, the difference between these types of capital can have dramatic effects on the willingness of banks to lend. Increasing common equity is crucial to getting banks to lend and lend responsibly, Wilson argues.
Wilson tells us:
I’m sure that Professor Krugman would not argue that we could solve the banking crisis merely by the government injecting debt into banks. Yet, preferred stock pays interest like debt and more importantly it is senior to common stock like debt. Preferred stock creates the same incentives as debt. Preferred stock does very little to help over levered banks.
Even if no new money goes into banks, common stock creates different incentives than preferred. Managers, if they are doing their job, maximise the value of common stock (not preferred stock). Limited liability means that a distressed bank will have perverse incentives until it has enough common stock to absorb those losses. With too little common equity, banks will pass up good loans because too many of the gains are realised by preferred stockholders and debt holders. Managers running banks with too little common equity will be tempted to make speculative loans and shift those losses onto senior creditors (preferred stockholders and bondholders).
This is intuition is confirmed by my research papers “Debt Overhang and Bank Bailouts” at and my joint work with Wendy Yan Wu “Common (Stock) Sense about Risk-Shifting and Bank Bailouts.”
The federal government has ensured that banks have no trouble borrowing today. The problem is they are not lending. If the administration wants to improve lending decisions, it should do so by encouraging banks to have a larger common equity cushion.
Crucially, however, a lot turns on whether the government gets a decent conversion price that reflects the market value of their preferred holdings. If the government converts preferred to common stock at a steep discount, it will not only screw taxpayers and hand a windfall to bank executives. It will also encourage reckless management by rewarding shareholders and managers for past recklessness. If the conversion is discounted too stepply, the new plan could, perversely, make banks even more likely to have to come back to the government trough by encouraging risky behaviour.