An efficient rescue plan

Roger Craine 09 October 2008

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Financial events moved like a firestorm during the last three weeks, easily jumping the firebreaks put in place by the Federal Reserve and US Treasury. Saving most financial institutions requires a quick and decisive responsive programme that strikes at the source of the financial implosion.

Problem: The credit market is frozen; most financial institutions are illiquid but solvent

Financial institutions borrow short and lend long. Lenders to financial institutions – other financial institutions and outsiders – fear that they may default. The fear is based on facts – Lehman, Bear-Stearns, and Wachovia failed. The spread between the three-month Libor (interbank lending rate) and the three-month T-Bill rate hit a 25-year high of 3.87% after the House passed the Troubled Assets Relief Programme (TARP) on Friday of last week. More importantly, the outstanding value of short-term interbank debt plummeted. Financial institutions don’t know the value of other institutions, and a premium of $4 per one thousand doesn’t make it worthwhile to investigate opaque assets and complicated counterparty obligations. The “risk premia” cannot clear markets with asymmetric information.

To restore the interbank lending market and control moral hazard, the government should:

  • First, guarantee the short-maturity debt (Fed Funds and CDs) of the financial institutions that join the plan and impose a capital requirement on all financial institutions in the plan.

The guarantee eliminates counterparty risk. Government-guaranteed financial institution short-maturity debt is default-free. The capital requirement eliminates, or at least mitigates, the moral hazard problem introduced by the guarantee. With no capital requirement, financial institutions have an incentive to borrow at the default-free rate and buy risky assets with higher average returns. Financial institutions that are close to insolvent have the greatest incentive to buy the riskiest assets. If the risky investment pays off, then they are solvent. If not, they likely would have failed anyway. This happened with a vengeance in the S&L fiasco in the 1980s.

In contrast to this plan, TARP focuses on buying toxic assets. Unloading toxic assets doesn’t eliminate counterparty risk and will not thaw the market in a time of crisis. The TARP would have to guarantee financial institutions against default to assure lenders. To control moral hazard TARP would have to regulate all financial institutions’ behaviour, i.e., nationalise them.

The debt guarantee plan is similar to the Futures Exchange Clearinghouse guarantee that makes trading among anonymous agents feasible. The Futures Exchange Clearinghouse guarantees delivery and payment on futures contracts so that traders don’t have to worry about counterparty risk. To give traders an incentive to perform, the exchanges require that they post margins, i.e., capital requirements. Banks now have risk-based capital requirements. These should be extended to all financial institutions that want the debt guarantee (and maybe all capital requirements should be increased because the world got riskier – margin requirements depend on price volatility.)

If a financial institution fails then the government takes control of it. The Futures Market Clearinghouse takes control of a client’s account if he or she cannot meet the margin call.

  • Second, the government should offer to provide capital to the financial institutions that join the plan for some interval – say, three months – in return for an equity share.

The capital requirement forces the financial institutions to have a stake in the outcome. Undercapitalised financial institutions benefit most from the guarantee. But, undercapitalised financial institutions must give up a share of equity ownership to participate in the plan.

The plan should be similar to the Warren Buffet model, but probably less demanding on the banks. If taxpayers put their funds at risk, then they should get a warrant that gives them a share in the appreciation if the financial institution prospers. They should also get some interest on the capital they provide, but Warren Buffet’s 10% seems like a lot. Remember that the goal is to restore a vibrant private financial market at the minimum cost to taxpayers.

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Topics:  Financial markets

Tags:  rescuing jobs and savings

Professor of Economics at University of California, Berkeley

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CEPR Policy Research