Bacon, Bad Banks and Risk Insurance

Today’s Irish Times reports that the government has hired Peter Bacon

to assess the possibility of creating a “bad bank” or risk insurance scheme to take so-called toxic debts off the banks’ balance sheets in a bid to free up new lending.

I know I’m at risk of sounding like a broken record on this topic but, given its importance, I’ll add my latest two cents on this. I’m not in favour of either this form of “bad bank” or a risk insurance scheme.

1. The “bad bank” idea (in its current meaning) involves paying higher than current market prices for impaired bank loans. This amounts to recapitalizing banks with taxpayer money without giving the taxpayer any further equity stake. If these banks survive the current era in private ownership, this will have turned out to have been a lump sum transfer from the taxpayer to the shareholders of these banks.
2. The insurance idea is basically a drip-drip version of the bad bank idea.

The insurance scheme probably seems more politically attractive because it delays the payouts and also because of the instant transparency of how bad the bad bank proposal is. As the IT puts it:

Under a bad bank scheme, governments would, in return for a charge on the banks, have to fund the purchase of bad debts upfront. The idea may force banks to recognise additional losses, creating higher demands for capital and leading to greater government ownership.

In other words, the bad bank idea mightn’t work because the public would need to see banks taking at least some of the losses. But this would probably require more government equity investment—and avoiding more government control of banks seems to be the political economy motivation for the scheme in the first place.

So, reading between the lines, the insurance proposal looks more attractive to politicians and also more dangerous to the taxpayer. As the IT article puts it:

An insurance scheme allows states to take losses over a longer period, mitigating the risk

which is an interesting definition of risk. Of course, the devil is usually in the details and perhaps our commenters can explain to me how this scheme can be implemented in a constructive way.

One justification for these proposals that has been put forward before in comments here is also alluded to by the IT:

without an insurance scheme or bad bank, uncertainty about future loan losses would remain, forcing banks to hoard capital and making them reluctant to lend.

In other words, some are arguing that the state can pay expected value for these assets and still improve the working of the banking system by shifting the uncertainty associated with large tail risk from the banks to the government. I suspect this is wrong on both counts. First, I don’t claim to know but I would guess that even the expected value of these losses likely equals the size of existing private capital. Second, the state guarantee effectively means that the tail risk of really bad outcomes is already implicitly being carried by the taxpayer.

Of course, if the banks end up being nationalized, these schemes will be irrelevant and it will be up to the state to fill the gap between assets and (insured) liabilities as best it can.