From recapitalisation to restructuring and reforms

Viral Acharya

12 October 2008

a

A

The G7 meeting has raised hopes that coordinated action at the global level will not only recapitalize several banking sectors expediently, but also provide further liquidity to markets, deposit guarantees and a backstop to money markets to restore funding for banks.

 

In light of this much-needed response to the global financial crisis, it is important to keep in mind that we must also deal with the lemons (in some cases institutions, and in other cases assets). This is necessary in order to provide the financial system with the resilience and the ability to raise private capital in near future. This should , in turn, help kick-start the currently moribund markets for inter-bank lending and commercial paper.

How we got here

The aftermath of Lehman Brothers' bankruptcy is best characterized as a complete collapse of trust between financial institutions and of investor confidence in these institutions (and to some extent in the very governments and Central Banks that regulate and oversee them). Over the past two weeks, a number of proposals have advocated public injection of capital into the troubled banking sector.1 Such recapitalization is rightly aimed at shoring up equity base of some highly leveraged institutions that have steadily made losses, and of others, less leveraged, whose equity base has suffered as a result of information spillover from adverse news about the highly leveraged ones. Partial or full nationalization is a temporary measure to put the patient on oxygen, but ultimately the arteries must be unclogged. Troubled institutions must be resolved, though not as abruptly as was the case with Lehman.

Options for restructuring troubled banks

There are at least two, not mutually exclusive, ways to achieve recapitalization.
• The first, which I prefer, is to identify and sell troubled institutions to healthier ones, possibly with government support in the form of loans or first-default-loss protections.2 The sale of Bear Stearns to JPMorgan in March is a good example of this method.
• The second is to restructure troubled institutions piece-meal, selling their healthier assets to other institutions and collecting the ones for which there is no current private interest into "bad banks", restructuring those assets, and resolving them over time. This is trickier given the complexity of institutions involved.

Two birds with one stone

Government-assisted sales to healthy institutions are an attractive way of deploying public funds since they kill two birds at the same time. They provide capital to the system, and entrust the complex task of orderly management and liquidation of troubled assets to the healthier parts of the private sector. Such sales also have the right properties in terms of not rewarding those institutions and managements that did poorly or refused to raise adequate capital in time.
Whether this mechanism suffices by itself to resolve troubled assets and institutions depends to an extent on the condition and willingness of healthy institutions and to some extent also on moral suasion powers of regulators. On the one hand, healthy banks stand to gain substantially from such sales. On the other hand, they may also try to extract their pound of flesh from governments and Central Banks, delaying acquisitions in order to deploy as little capital as possible. The latter may however still be the preferred outcome given the huge legal and administrative costs of the alternative.
The alternative arrangement of resolving some institutions piece-meal was employed during the US Savings and Loans crisis as well as in the 1997 East Asian crisis. In the current context though, this requires substantial clarity on how creditor recoveries will be distributed, especially given the complex, contingent and international nature of debt. As such, this will call for seamless cross-border coordination.3
Even if we ignore this rather important issue, holding on to difficult assets requires having a long-term horizon as they may not be easy to liquidate as and when needed. Currently, there are few private investors with such horizons. The non-banking financial sector might be able to muster some capital swiftly to buy such assets at attractive prices, but in a severe systemic crisis such as the one we are in, this sector is liquidity- and capital-strapped too. Hence, the restructuring vehicles would have to be prepared for a somewhat protracted resolution of these assets.
As a result, having the restructuring option in place might provide enough potential competition to give incentives to healthier players to make acquisitions sooner and at non-extortive terms. Nevertheless, government-assisted bank sales overall present a better form of public-private partnership. I am afraid though that both may ultimately be required and avoiding some messy restructuring may be unavoidable.

Trading of Credit Default Swaps on exchanges

In addition, the efforts underway to move trading of credit default swaps to exchanges where collateral arrangements can mitigate counterparty risk must be bolstered by similar longer-term arrangements for mortgage-backed securities and standardized securitization products. Such infrastructure would be essential if the recapitalized financial system is not to experience paralysis in response to further adverse news, which might deplete the capital pool and necessitate additional asset sales and restructuring. Indeed, creating more transparent platforms for unsecured inter-bank lending in which public funds are initially deployed to provide first-default-loss guarantees, with these guarantees eliminated over time, also present an attractive option.4 All these measures would eventually reduce the burden on the Central Banks to take on credit risk in their lender-of-last-resort operations and emergency liquidity assistance schemes.
While recapitalization employs public funds to get at the issue of insolvency, these other efforts employ public funds more directly to reestablish liquidity in several markets that are shut down, and build infrastructure to ensure their smooth operation in future. In the first case, preferred stakes may potentially provide the taxpayers a good return. In the second case, this return is provided by eliminating the negative externality of troubled, illiquid assets on healthier parts of the system and creation of public goods.

Conclusion

A joint resolution of the issues of inadequate capital and of troubled assets and dysfunctional markets is required to restore efficient transfers of liquidity between financial institutions and the rest of the system. Until such efficiency is attained, financial institutions will continue to hoard liquidity and ration credit, preventing economies to emerge from the trap of diminishing levels of financing and growth.
Recapitalization of banking systems is just the beginning. A series of restructuring efforts and reforms, some short- and some long-term, aimed at restoring the orderly functioning of markets, must follow with urgency and conviction.
 

 


 

1  Public recapitalisation of the financial sector was the single most common feature in opinions of leading academics in VoxEU’s recent publication “Rescuing our jobs and savings: What G7/8 leaders can do to solve the global credit crisis”.

2 Under reasonably general assumptions, government-assisted bank sales can be shown to be as effective – ex-post and ex-ante – as bailouts structured through a recapitalisation. See Viral V Acharya and Tanju Yorulmazer, “Cash-in-the-market pricing and optimal resolution of bank failures”, The Review of Financial Studies, 2008, forthcoming.

3 This is also the primary difficulty with debt-for-equity swaps which otherwise seem a reasonable alternative.

4 Some proposals, e.g. in the VoxEU publication cited above, have suggested even complete government guarantees of inter-bank lending in the short run.
 

a

A

Topics:  Financial markets

Professor of Finance, Stern School of Business, New York University and Director of the CEPR Financial Economics Programme

Events