Promising signs of progress in the ‘Bad Bank' Plan

Posted by on 4 March 2009

Respected analysts have urged nationalization and the creation of bad banks. Martin Wolf’s recent column in the FT To nationalize or not – that is the question? focuses on the nationalization of the banking system. Martin correctly points out the discussion of “to be or not to be” is merely a question of semantics. It is important to realize the decision to nationalize the core of the banking system is far more nuanced and requires careful reflection. One can only surmise the constraints that the administration is facing:
• Sovereign investment funds might not try again to “catch a falling knife” and invest in the recapitalization of banks after losing their investments.
• Cross border banks are not only big to manage, they are equally complex to resolve. The AIG experience is indicative of the unanticipated consequences of ownership. Citibank is present in over 100+ countries with different laws and potential contingent liabilities.

Further, the nationalization of a financial institution by itself does get to the core of the problem: the resolution of impaired assets. The timely resolution of impaired assets is important for at least two reasons. Foremost, in order to encourage future lending and discourage moral hazard. For instance, FOBAPROA (Fondo Bancario de Protección al Ahorro or "Banking Fund for the Protection of Savings") was created in Mexico in 1990 in an attempt to resolve the liquidity problems of the banking system. The Fobaproa was applied during the 1994 economic crisis to prevent the insolvent Mexican banks from going bankrupt. However the program failed, and the recoveries were minimal. As a result the recovery of lending in Mexico was lethargic -- lending (as a percentage of GDP) recovered to the pre crisis level only around 2005. Second, the losses in the financial system are not static, but rather endogenous and depend on the vigor and speed of the resolution process. Benign neglect through blanket guarantees and emergency treatment in the government’s “emergency room” inevitably leads to an increase in losses though slower recovery processes and deterioration in asset quality. Under reasonable assumptions, the ultimate impaired assets costs could double the initial costs.
In this context, it was encouraging to see that the Obama administration is incorporating those considerations in their plans. The WSJ reported on March 3, 2009 that the US Treasury ‘Bad Bank' Funding Plan is starting to get fleshed out (http://online.wsj.com/article/SB123603913648314649.html). The administration is considering creating multiple investment funds run by private investment firms in private-public financing partnerships to purchase bad loans and other distressed assets. The managers would be asked to put up a certain amount of equity capital and additional equity and working capital financing would be provided by the government, with sharing arrangements of the profit or loss. The rough outline suggests that the Secretary of the Treasury is on the right track in trying to address the problems. The approach deserves consideration and support from the policy making and financial communities. It has several merits:
- This design ensures that troubled assets are worked out in the private sector. The government bureaucracy does not have the expertise or the motivation to make decisive decisions in the resolution of troubled assets. In fact, one of the forgotten lessons from the S&L crisis is that the Resolution Trust Corporation only got going and become effective, after it started auctioning impaired assets to the private sector. Prior to that decision, the resolution process was in limbo.
- The proposed approach secures private equity capital, while providing government working capital. The program further ensures that the incentives of the managers are aligned with the public interest by having their own money at risk.
- The program creates capacity and competition in the private sector to deal with the mammoth impaired assets problem.
It is equally important to recognize that the proper design of the funds is not an easy task. To my knowledge there are only two prior efforts to create such funds in Korea and Israel. Korea used distress funds on a limited scale with very mixed results during the Asia crisis. The Korean experience is documented in Corporate Restructuring Funds: The Lessons from Korea by Christopher Vale in Corporate Restructuring: Lessons from Experience by Michael Pomerleano, William Shaw, World Bank, 2005. Chris Vale, the principal of one of the funds that operated in Korea, offers an informed and candid perspective on why the Korean corporate restructuring funds were not as effective as they could have been (( books.google.com/books?isbn=0821359282 ). In a nutshell, the funds had multiple and conflicting objectives and therefore were unable to attract private capital to match government funds.
Israel is currently experimenting with the resolution of distressed debt by creating “leverage funds”. The Israeli Finance Ministry is in the process of creating joint public-private funds to lend money to companies with cash-flow problems, in order to help them repay their debts. While the basic concept has virtue, the ability to attract private funds and to be effective is not tested. Those cautionary tales suggests that it is important for the Obama administration to proceed with caution and get the incentives right.
The ideas presented in the WSJ are too vague to express a conclusive view. However, the administration seems to be coming up with a sensible plan to resolve the present morass. Let’s remember that Winston Churchill said: “You can always count on Americans to do the right thing - after they've tried everything else”.