http://www.irishtimes.com/newspaper/breaking/2009/0210/breaking23.htm

you will be glad to know that I have already spotted the above and I am currently applying for a banking license. I think depositors will be tempted through sheer annoyance with the current set up. watch this space

European Commission sets out guidelines for bad banks

FT Deutschland has obtained a paper prepared by the Commission for today’s Economic and Finance Committee meeting in Brussels, which includes a detailed set of procedures European governments should be following in setting up bad banks. The Commission wants that toxic assets are written off at market value, and that any write-offs will first have to come out of shareholders’ capital. Once the capital falls below the Basel ceilings, it is up to the government to provide new capital, or to force the bank into bankruptcy procedures. All fine and good, but how about the small problem that there is no market for most of these assets, and thus no market price? The article says the Commission wants to leave that little detail to the bank supervisory authorities.

One of the problems with discussions on this issue is the confusion created by multiple possible meanings of “bad bank”. The good meaning (Patrick’s meaning) relates to the best way to minimise taxpayer losses after nationalisation: Putting together a team of workout experts to get the best prices over time for the bad assets. This is what the Resolution Trust Corporation — apparently many people’s model for the “bad bank” — did with failed S&Ls.

The bad “bad bank” proposal involves taking over one insolvent bank (for instance) and using it to go out and pay over the odds for other banks’ toxic assets. This is my interpretation of most of the casual references to bad banks lately and this just seems like a bad idea. Insuring the losses on bad assets is just as bad — the only difference being that governments will be paying out in a drip-drip fashion instead of straight off.

Beyond all of that, given the multi-faceted problems related to dealing with failing privately-owned banks, there still seems to me to be some merit in using at least some of the large amounts of money being used internationally for re-capitalizations ($350 billion is a lot of money) to set up some completely new banks (not just the “new WAMU” or “new B&B” banks associated with FDIC-style purchase and assumption procedures.) But perhaps it’s just not practical.

It is in fact equivalent to the nationalization+bad bank proposal.

Thus, obviously the new bank would acquire all or most of the branches and take on all or most of the staff (but not top management). It benefits from an injection of government capital. And it is to be sold back into the private sector as quickly as possible.

So it is essentially identical to the solution adopted in WaMU and Bradford and Bingley as evoked in my paper for the crisis conference last month.

(One small but significant difference — subordinated bondholders in those banks took a bath, whereas some of them have a government guarantee for the next 20 months).

The government gets involved in the property. It buys property that is likely to be of value to it for around half (or a third or whatever) the peak price. That will effectively allow cash to be returned to the banks, although not too much. It will also draw out any other land purchasers. Worst case scenario, the property would still not be worth a lot, but the government would actually own something and would avoid getting too deeply involved with the management of the banks.

The next big issue is going to be commercial debt as the recession takes hold. It’s a lot harder to quantify the value of commercial debt than it is property debt.

I have been following your prosposal and ensuing discussion with interest. I was initially sceptical, but am starting to see the case for what you suggest — even for Ireland.

Can you let me know if I’ve got the key elements straight?

Good banks–
Assets: “Good” assets from the legacy banks, government bonds, and new loans over time
Liabilities: All guaranteed liabilities from the legacy banks
Ownership: Initially government, but private equity raised over time, with eventual full privatisation
Branch network: Network of the legacy banks
Not quite sure what happens to previous owners of legacy banks. Some options: (i) wiped out completely; (ii) compensated based on remaining value of legacy bank; or (iii) given an ownership stake in the new bank

Bad banks–
Assets: Remaining “toxic” assets from the legacy banks
Liabilities: None
Ownership: Government
Challenge: Managing the asset portfolio to recoup value for the state. (Niggling questions: Who would do the managment? How much forbearance is optimal? How much forbearance is likely given inevitable politicisation?)

A great advantage is that it provides more clarity on the commitment of the state, which I’m assuming would be very large. Of course, there would still be uncertainty, including the ultimate value of the toxic portfolio. A disadvantage is that this clarity is likely to come with some sticker shock.

One final worry: Will there be many willing creditworthy borrowers for the good banks to lend to in the immediate future? Maybe we just need to be patient.

On the other hand, we’ve never had the opportunity to lose quite such large amounts of it either.

Buiter writes about his “new good banks”: “Under my new good banks proposal, the new good banks would take on the (guaranteed or insured) deposits of the legacy bad banks (which would lose their banking licenses) and would buy the good assets of the legacy banks. Should deposits exceed good assets, the state would have to make up the difference initially with government debt on the balance sheet of the new good banks. Should deposits be less than good assets, the new good banks would be able to borrow from the sovereign to finance the acquisition of the good assets from the legacy bad banks. This would cleanse bank balance sheets and transform them into good banks but leave them undercapitalized. Soros suggests that $1 trillion of the estimated $1.5 trillion required to recapitalise the existing banking system should be directed to the cleansed banks. Soros believes or hopes that some of the money required to capitalise the new, cleansed banks could come from the private sector. Under my proposal, and that of Stiglitz, the state would initially capitalise the new banks on its own. “

http://blogs.ft.com/maverecon/2009/02/good-banknew-bank-vs-bad-bank-a-rare-example-of-a-no-brainer/

“The US, the UK and several other continental European countries are at risk of emulating Ireland, where the government first guaranteed all the liabilities of the banks (other than equity) and only after that began to nationalise the banks. This leaves the Irish government today in the not too enviable position of having to choose between sovereign default and bleeding the tax payer and the beneficiaries of normal public spending to make whole all the creditors of the banks.”

And there are other, more subtle, financial engineering solutions available (some of them discussed here already) which might give better protection against moral hazard and againt risk of short-termist political influence over lending decisions. Some of these are also being discussed elsewhere.

But Ireland is a bit exposed now to be innovating here. That’s why I have been suggesting a wait-and-see attitude, in anticipation of announcements from US, Germany and UK in the coming weeks. We could more safely follow an established exemplar.

Any intervention now does limit our options. Saturday morning’s newspaper articles suggest that what is currently on the table is generically the same as UK-type intervention of last October. (But we assume this is a selective leak). As such, it may be less limiting than some other options.

But still…a little patience seems best, even if the banks are frustrated at their lack of financial independence, and even if allowing undercapitalized banks to operate entails some risks.

This being the case, what is the case for having a private banking system? I mean, I thought the market is supposed to be better than the state at providing goods/services because the inefficient go out of business. If we can never let banks go bust, then what?

That said, I still think these proposals provide some useful food for thought in the Irish case. They help in clarifying that the issues of dealing with failed banks on the one hand, and getting new lending going, on the other hand, can (at least in theory) be separated. For sure, with deposit (and other) guarantees in place, it is in all governments’ best interests to deal with insolvent banks in the most orderly way possible and to get as much as possible in return for their assets. But using taxpayers money to deliberately overpay for bad assets or fully recapitalize existing banks are not necessarily the only options.

Bottom line - setting up a replacement banking system is logistically a nightmare and there are significant second and third order effects especially in a small economy that need to be carefully thought out. We do not live in a model - we live in a society and a networked economy, and we need in our policy presctiptions and musings to remember this. Else there is a serious danger that the best will become the enemy of the good in relation to the rapidly accellerating mess we are in. Its best, imho, to fix the exisiting banks (and yes, have a toxic bank) than to experiment with ideal world models. We are in a storm and redesigning the ship on the hoof is probably not a good idea - best to patch the holes and sail for calmer water

But something somewhere has to give sooner or later. Perhaps we just have to hang tight until the EU decide to devalue the euro. “We’ll vote Yes to Lisbon if you devalue the euro”

As events unfold, it becomes clear that the guarantee was a stroke of genius by the banks. The Government thought they were throwing the banks a lifeline, in fact the guarantee has lashed the country’s fortunes to the future of the banks.

Brian Cowen told Marian Finucane this morning that he sat in silence while the bankers made their case on that (in)famous night of 30 September. He said the bankers then left the room and the Government made the decision independently. The course of our economic history was changed on that night and we may never know the full story.

The ‘Debt Securities in Issue’ (bonds?) are only 17b, less than the 22b reported by the Irish Times; I suspect the Irish Times article I linked to above was using out of date data from 2007 http://www.angloirishbank-interim-results.com/consolidatedbalance.asp

Here’s the 2008 figures.
http://www.angloirishbank.com/Investors/Reports/

http://www.mortgagebrokers.ie/blog/index.php/2009/02/06/understanding-deposit-lending-margin-relationships/