What next?

Douglas Diamond, Anil Kashyap , Raghuram Rajan 09 October 2008

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We are in a midst of a banking panic caused by concern over the quality of bank assets and the adequacy of bank capital. Interbank lending has stopped and lending to non-banks is grinding to a halt. We need intermediaries to begin functioning again to avoid a deep recession.

The historical recipe for stopping a panic is an automatic stay (or suspension of convertibility) that freezes the ability of creditors to withdraw their money. This buys time so that authorities can audit the banks, decide who is solvent, wind down or recapitalise the shakiest banks, and stop the panic. Today, however, short of failing a bank, such a stay on short-term debt or deposits is impossible.

Perhaps the various guarantees made over the last couple of days will end the panic. But we must prepare for the alternative. If the panic continues, it can be stopped with the traditional tools of auditing, certification, recapitalisation, or asset liquidation. The challenge is to be ready with a plan to accomplish this within the law and without increased incentives for short-term creditors to run.

Our plan is for regulators to buy time by guaranteeing all banks’ short-term liabilities for a brief period. This would amount to saying that all securities maturing in the next three months would be federally guaranteed and could be rolled over up to five months. To prevent gaming, asset growth would need to be limited to normal lending growth. Dividend payments would be stopped.

The timeout would be used to verify asset quality and establish capital adequacy. This would start with rapid audits of bank assets, marking to market using common pricing assumptions across banks (above fire-sale values), with the goal of establishing the relative net worth of the banks. Banks would be invited to raise additional capital, with the understanding that any capital raised would be senior to existing capital (except perhaps recently raised capital). If the banks subsequently needed to be liquidated or required government capital infusion, these new investors need the assurance they will be protected (their seniority respected) – otherwise they will not participate. The banks that emerge with higher capital could use the funds to buy weaker banks. The weakest banks, which no one wants to buy, would be wound down. If it turns out that a number of banks are insolvent, even though their core capabilities such as local knowledge have value, they could be failed and recapitalised by the government (without imposing any losses on the short-term creditors).

This plan should be viewed as a stopgap measure. It is possible that the asset purchases under the Troubled Asset Relief Program will eventually help, both to allow banks to sell without depressing prices and to allow the market and regulators to value banks. Likewise, schemes aimed at stabilising home prices, if done on a massive scale, could influence the value of bank assets. But these types of solutions are infeasible in the short term and helpful only if investors believe that they will stop the bank run and make banks solvent. With the number of at-risk institutions growing every day, stabilising the banking system must be the first priority.

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Topics:  Financial markets

Tags:  rescuing jobs and savings

Professor of Finance at University of Chicago’s Graduate School of Business

Edward Eagle Brown Professor of Economics and Finance at the Booth School of Business, University of Chicago

Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Graduate School of Business

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