Interaction Effects of the Bank Liability Guarantee and Asset Purchase Schemes

Both the Irish bank liability guarantee (instituted in September 2008 and likely to be renewed) and the asset purchase scheme (likely in place soon via NAMA) have been controversial, and their strengths and weaknesses have been widely debated.  Less attention has been paid to the powerful interactions between these two schemes.   If both schemes go ahead, perhaps these powerful interactions could serve to improve overall cost-efficiency and policy effectiveness.

I want to make an argument which does not lean too heavily on particular parameter values but instead relies on basic ideas from applied economic theory.[1]  Suppose for simplicity that the economy (and therefore taxpayers) would be badly hit by removing the bank guarantee, and the banks would suffer devastating bank runs.  Hence both parties (taxpayers and bank management) benefit substantially from having the guarantee in place.  The payoff matrix is one-sided with both parties benefitting from instituting the guarantee:

                              Taxpayers                     Bank Managers

Liability guarantee       +                                  +

No Liability guarantee                                    

Obviously the two parties will agree to institute the bank liability guarantee.  The bank managers may succeed in bargaining for underpricing the liability insurance, particularly if there are only a few dominant banks in the economy so that each dominant bank has bargaining power against the taxpayers. The banks’ off-equilibrium threat not to participate in the programme unless the insurance is under-priced is not credible, but the bargaining solution in terms of insurance price is not determinate.

Next, the taxpayers propose an asset purchase scheme to the banks.  The ordering of the two steps is important (first the guarantee, then the asset purchase proposal).  Since the liability guarantee is in place, the banks can bargain very hard over the terms of the asset purchase. The banks hold a potentially enormous put option on their net value, with the put option issued by the taxpayer via the liability guarantee.  This gives the banks the power to bargain hard over the asset purchase scheme pricing, and credibly threaten to drop out of the asset purchase scheme if it is priced fairly (since much of the fair value of the scheme accrues to the taxpayers via their put option liability).  The banks can bargain hard, by threatening to waste taxpayer funds (in the form of the written put option).  Getting them to participate requires excessive valuation, not fair valuation.

An obvious improvement in the two schemes is to tie them together.  Banks should be eligible to participate in the renewed liability guarantee only if they accept the asset purchase programme with fair-valued (not over-valued) pricing.  This could save billions in the pricing of the asset purchase scheme, and ensure ready acceptance by the banks.  In the cut-and-thrust politics of current NAMA debate, this note may seem academic, but I argue that the point is valid and might even be helpful.

 

[1] I have been reading a lot of Ken Rogoff recently.  See, e.g., This Time Is Different by Carmen Reinhart and Kenneth Rogoff, Princeton University Press.


6 thoughts on “Interaction Effects of the Bank Liability Guarantee and Asset Purchase Schemes”

  1. @Gregory Connor,

    Thank you for this post. I think it is of more than academic interest. It highlights the fact that, once the blanket guarantee was awarded, the State was on the back foot in its dealings with the banks. There probably was a small window of opportunity to pursue the “nuclear option” – aka Prof. Stiglitz’s “rules of capitalism” – i.e., nationalisation, wipe-out of all investors, cleansing, recap and resale accompanied by a thorough shake-out of the property market, but this has long gone. If pursued it is likely it would have led to extensive external ownership and management of the cleansed banks (and of the property sector – even if a tranche of Irish net wealth held externally might have been tempted back to devour the temporarily under-priced pickings).

    All the international and historical evidence seems to suggest that a rapid and thorough, if painful, adjustment is more beneficial in the medium to long term. The Government set its face firmly against this approach primarily because of a failure to draw a distinction economic activities and those who perform them. The very simple economic point that seems to have been missed is that, while there is a continuing demand for them, the identity of those performing economic activities is irrelevant. Those who fail – and, as in this case, fail catastrophically – in the performance of an economic activity have no entitlement to continue. This is the essence of capitalism and competitive markets. Those who fail move on and those who envisage a prospect of success move in.

    NAMA is the result of the Government’s desire to maintain some vestige of Irish ownership and control of the banking and property sectors and of its attempt to reduce the State’s exposure under the blanket guarantee. And the bankers and developers who created the mess, to a considerable extent, remain in situ and hold the whip-hand over citizens who retain a signifciant liability. Meanwhile those who benefited least, in relative terms, from the false boom are likely to suffer the most in relative terms.

    Certainly not a recipe for social cohesion, democratic stability or future prosperity.

  2. This analysis falls at the first hurdle. The bank guarantee scheme confers no bargaining power to the taxpayer. Picture the following analogy. I am flying in a plane which develops a very serious technical problem, to which I alone have the solution. The pilot advises me that if I don’t supply the solution the plane will crash. Where is my bargaining power? Can I really insist on free travel for life in return for my co-operation?

  3. The premise is also false. The guarantee is and always has been a mirage since it can never be honoured. A run on the banks could still be triggered by a realisation of it’s lack of substance, or another call to the Joe duffy show. As Bertie tried to say it’s all smoke and mirrors

  4. “Banks should be eligible to participate in the renewed liability guarantee only if they accept the asset purchase programme with fair-valued (not over-valued) pricing”.
    Sadly Lenihan’s idea of fair pricing is overpay as much as possible to avoid substantially nationalising the banks. But if the government fell tomorrow perhaps this approach would work.

    Given the holes that Anglo and Nationwide have become we should simply have dared the bondholders to send them over the cliff.

  5. @Gregory Connor

    Thanks for that. The interraction of NAMA and the Guarantee is certainly of primary importance.

  6. I agree that policy in this area is of vital importance particularly if we insist on borrowing so much to fund deficits and Nama, all political choices that should be put to the electorate.

    A review is, almost literally, vital.

    I highlight Steve Keens recent article by showing his para on the effects of a Federal Gov multiplier. Premature use of this multiplier will destroy more capital than it protects. Waiting past the optimum moment will simply mean inflation in asset values above the proper level. Whatever it might be. All relative. As Ireland has structural liabilities where Australia has structural assets, the circumstances need to be teased out. Nama effects will still be negative for all the reasons of my previous posts.

    http://www.debtdeflation.com/blogs/2009/11/02/debtwatch-no-40-november-2009-have-we-dodged-the-iceberg/

    “The FHV then took this additional cash and leveraged it into an additional $200,000 or so for their next house purchase. So the FHVB caused a bubble, not merely in the sub-$500,000 price range that most First Home Buyers inhabit, but right up to the $1 million range that accounts for more than 90% of Australian housing. The leverage on the FHBB was not merely seven to one, but closer to 50:1 given this flow-on effect.”

Comments are closed.