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.
How we got here
Options for restructuring troubled banks
• 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
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
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.
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.