VoxEU Column Financial Markets

Governments should buy straight preferred stock in their banks

To give banks capital and liquidity while protecting taxpayers, governments of the G7 should buy straight preferred stock in their banks.

The G7 needs to follow the UK's plan, and do so on a coordinated basis. That plan has two parts. First, the governments must work together to share the burden of standing behind interbank borrowing in the LIBOR market for a brief time (probably not to exceed a month), and also continue to support the commercial paper market. This burden sharing follows from the fact that these banks are international entities. But this is not a long-term solution, and without a long-term solution this kind of support could encourage very risky behavior by the banks.

The second part of what must be done immediately -- government purchases of straight preferred stock -- also copies the UK plan. Why should the governments of the G7 buy straight preferred stock in their banks? This adds capital and liquidity immediately to give banks the room to manage their asset quality and liquidity problems, while ensuring that common stockholders are in a first-loss position, not taxpayers.

The details of how the preferred stock is designed are crucial to its success. Since taxpayers are not in a first-loss position (as in asset purchases) there is no need to add upside warrants or other options, and these are not helpful. The governments should not attach warrants or convertibility options to the preferred stock, since doing so would dilute common stock and make it harder to raise common shares, which would be counterproductive.

Coupons on the preferred should be set very low (zero would be fine with me, or the treasury bill rate) for the first two or three years, and then the coupon should jump to market rates (indexed to some benchmark) subsequently. The initial low coupon will provide an immediate limited up front subsidy that will help to recapitalize banks.The preferred shares should be callable so that banks can exit the arrangement as soon as they are back on their feet.

Government should select banks on a broad basis of availability, but should decide immediately and in advance which banks have to be merged out of existence, and disqualify them from receiving any funds. The remaining banks would receive funds on a pro rata basis relative to assets under management (as in Finland in 1992).

Common stock dividends should be set to zero for all banks receiving assistance for the duration of their use of the preferred shares. Banks receiving assistance should have to devise and defend a capital plan (for raising common stock), and must grant veto authority over major corporate decisions (e.g., mergers and acquisitions) to the government (to prevent asset substitution risk).

Both aspects of this plan could be announced immediately and implemented very quickly (within a week, giving time to the FDIC or other similar authorities) to determine which banks will not qualify. Note that this process is virtually identical to the successful implementation of the Reconstruction Finance Corporation's preferred stock program in 1933.

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