Financial crisis resolution:
It's all about burden-sharing
Charles Wyplosz [1]
20 July 2008

  Should taxpayers bail out the banking system? One of the world's
  leading international macroeconomists contrasts the Larry Summers
  "don't-scare-off-the-investors" pro-bailout view with the Willem
  Buiter "they-ran-into-a wall-with-eyes-wide-open" anti-bailout
  view. He concludes that either way, taxpayers are always the
  losers. The best policy makers can do is to be merciless with
  shareholders and gentle with bank customers.

An old and familiar debate is back. Should taxpayers bail out the US
banking system, quite possibly the British and European ones as well?

There are two standard views on the multi-trillion dollar question of
who pays for getting us out of the financial crisis:

* One view is that the situation has become so desperate that
  ordinary citizens will in any case be paying a high price for the
  crisis; throwing money at banks right now might lower the overall
  burden by preventing a deep, protracted recession.

* The other view is that banks ought to be left hanging to pay for
  their sins. Governments ought to be worried about their taxpayers,
  not bank shareholders.

In fact, we don't have that much choice.

Too big to fail: the Bagehot rule
---------------------------------
It has long been a poorly hidden secret that large banks cannot be
left to go bankrupt. Walter Bagehot, a 19th century economist and
editor of The Economist, designed the solution that remains as
relevant today as it was then. The Bagehot rule is that the central
bank ought to lend freely to a failing bank, against high-quality
collateral and at a punitive rate.

The modern version of the rule adds that shareholders ought to bear
serious costs and the managers ought to be promptly replaced. This is
exactly what happened with Bear Stearns last March, where another
bank, JP Morgan, was used as the conduit for the operation. The cost
to the taxpayers was a $1 billion guarantee and a $29 billion loan to
JP Morgan guaranteed by Bear Stearns assets. We don't yet know if this
was a taxpayer-financed bailout. If JP Morgan redresses the situation
within ten years, the taxpayers will make a profit. If not, US
taxpayers will have borne the burden. Bear Stearns shareholders were
almost completely expropriated.

As the US economy keeps limping and the housing market deteriorates,
most observers believe that there will be many more bank failures.
Indeed, in early July, a large Californian mortgage lender, IndyMac,
went belly up and was also subjected to Bagehot's recipe. The
possibility that some very large financial institutions, and many
smaller ones, will follow provides urgency for the current debate.

The Larry Summers school of thought: Don't scare off the investors
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One school of thought — let's call it, fairly I think, the Larry
Summers School — is that the Fed has been far too tough with Bear
Stearns. It has scared investors and managers alike. The result is
that investors are now unwilling to provide much needed cash to banks
that must rebuild their badly depleted balance sheets while bank
managers strenuously resist acknowledging their losses and continue
selling their toxic assets. As a result, the whole banking system is
in a state of virtual paralysis, which means that borrowing is both
difficult and costly.

Lowering the interest rate, as the Fed vigorously did, does not even
begin to redress the situation. This all leads to a vicious circle
where insufficient credit drags the economy down, which leads to more
loan delinquencies, which further impair banks ability to lend.
Memories of 1929 immediately come to mind, when the Fed made matters
considerably worse by clinging to financial orthodoxy.

This school of thought fears that the same fascination with
high-minded principles turns a bad crisis into another nightmare of
historical proportions. The Larry Summers School wants the Fed to lend
freely and more generously with the goal being to reassure potential
investors. If that is done, so goes the argument, banks will be able
to rebuild their balance sheets and resume their normal activities.
This would signal the end of the now one-year old financial crisis as
a virtuous circle unfolds — more loans, a resumption of growth and the
end of the housing market decline, healthier banks, and more loans.

The Willem Buiter school of thought:
------------------------------------
They ran into a wall with eyes wide-open
----------------------------------------
The other school of thought — let's call it, a bit unfairly, the
Willem Buiter School — sees things in the exact opposite way.

The crisis is the result of financial follies by financial
institutions that bought huge amounts of products that they did not
understand — the infamous mortgage-backed securities and their
derivatives — parked them off-balance-sheet to avoid regulation, and
made huge profits in doing so. In short, they ran into a wall with
wide-open eyes.

Once the all-too-well foreseen crisis erupted, these institutions kept
hiding the extent of their losses as long as they could — they are
still playing that game — and started to lobby for a bailout from
their governments.

The classic credit cycle: Look who's crying now
-----------------------------------------------
This school notes that the crisis is part of a classic credit cycle
that involves excessive risk-taking in good times and ends up in
tears. The question is: whose tears?

The challenge is ensure that these are not the taxpayers' tears.
Indeed banks are in a unique position. They used to call for a bailout
to protect their depositors, but deposits are now insured in all
developed countries. Still, because bank credit is the blood supply of
the economy, we cannot let our banking system sink. But once banks
know that they can play the high-risk, high-return game, pocket the
profits, and let taxpayers face the risks, bailouts provide a
temporary relief but set the ground for the next crisis.

Wilder and wilder parties
-------------------------
Bank of England Governor Mervyn King nicely sums up the situation:
"'If banks feel they must keep on dancing while the music is playing
and that at the end of the party the central bank will make sure
everyone gets home safely, then over time, the parties will become
wilder and wilder."[2] Bagehot principles can be applied when one or
two banks fail, but when the whole system is under threat, this is no
longer an option.

Which school is winning with policy makers?
-------------------------------------------
Both schools have developed consistent views. The dismaying part of
the story is that they lead to radically different policy
implications.

So far, the monetary authorities have been closer to the Willem Buiter
School view, but things may be changing. The most recent bailout of
Fannie Mae and Freddie Mac is clearly a soft rescue operation, with no
set limits and, so far at least, no penalty on shareholders and
managers. Even though Fannie Mae and Freddie Mac are very special
institutions with a federal mandate, the Larry Summers School is right
to see some glimmers of hope and therefore must be taken seriously.

In most respects, we have gone through a very classic credit boom- and
bust cycle. Two cases from the 1990s are worth pondering:

* Following years of fast bank credit growth accompanied, as
  should be, by housing price bubbles, bank crises started in 1990
  in both Japan and Sweden. The Swedish authorities reacted swiftly,
  bailing out most banks at a cost to taxpayers estimated at some 4%
  of GDP, but shareholders were essentially expropriated.[3]

* The Japanese authorities protected their banks with generous
  loans, even as some banks were serving dividend payments to their
  shareholders.

Sweden recovered in three years and, nowadays, Swedish banks are not
found among those that indulged in mortgage-backed securities. Japan
has still not recovered from a nearly twenty-year long "lost decade"
and, nowadays, several Japanese banks have already failed under the
weight of the toxic assets that they acquired, once again.

Figure 1: GDP Growth in Japan and Sweden [img]

Conclusions
-----------
Of course, there is more to it than this simple comparison, including
the accompanying macroeconomic policies. But three unmistakable
messages emerge:

* Be merciless with shareholders and gentle to bank customers
* Either way, taxpayers are always the losers.
* Bagehot had it all right.
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[1] Charles Wyplosz 
Professor of International Economics at the Graduate Institute,
Geneva; Director of the International Centre for Money and Banking
Studies. CEPR Research Fellow
[2]
http://business.scotsman.com/business/King39s-stark-warning-to-banks.4171575.jp
[3] Peter Englund, "The Swedish Banking Crisis: Roots and Consequences",
Oxford Review Of Economic Policy 15 (3): 80-97.

Source: http://www.voxeu.org/index.php?q=node/1431