William White: Still Need to Deal with Bad Debt
In his Financial Times editorial, William White urges we prepare for the next financial crisis now. For those of you who don’t know who Mr. White is, he is one of the handful of macro-economists who warned about the Great Financial Crisis before it occurred. He is also the chairman of the economic and development review committee at the OECD.
While this is good advice, it is a little premature as we haven’t ended the Great Financial Crisis. Since the acute phase of the crisis started in 2008, I have said given the stated goal of “foaming the runway” for the banks to absorb losses on their bad debt exposures you cannot consider the financial crisis over until all the emergency policies put in place to support this goal have been ended.
Examples of these policies are zero interest rates, central banks paying interest on excess reserves and quantitative easing. Each of these policies is designed to positively impact bank earnings. Zero interest rates reduces banks’ cost of funds. Interest on excess reserves boosts banks’ income. Quantitative easing allows banks to generate trading profits by front running central bank securities purchases.
Regular readers know I have said and shown why the goal of “foaming the runway” and the related policies were and are fundamentally flawed. Mr. White confirmed a significant problem with these policies too:
With markets unable to allocate resources properly, due to the actions of central banks, the likelihood that rising debt commitments will not be honoured has risen sharply.
Oops.
Policies to foam the runway didn’t result in bad debt being eliminated from the global financial system (In the absence of transparency, why would anyone think this would occur?). Instead, Mr. White confirms they significantly increased the amount of bad debt in the global financial system.
So what does Mr. White recommend to address this problem?
Perhaps most important is the need for governments and international forums to revisit bankruptcy procedures. Debt that cannot be serviced will not be serviced. Governments must enact legislation to ensure this can happen in as orderly a way as possible. Unfortunately, recent work at the OECD indicates that bankruptcy procedures for private agents fall some way short of best practice in many countries. Nor, despite great efforts, have we adequately improved our legal capacity to deal in an orderly way with banks that are no longer viable, but are still “too big to fail”. Procedures for the restructuring of sovereign debt are inadequate too.
Here we are a decade after Paulson, Geithner and Bernanke led the charge to “foam the runway” for the banks and we still haven’t made it possible to deal with bad debt in an orderly way. Clearly, this was intentional.
Consider the case of Iceland. It figured out how to eliminate all the debt that would not be repaid in its financial system without creating “equity” for the borrowers who had their debt reduced. They did this within a year of the onset of the acute phase of the financial crisis.
But what about the rest of the global financial system? What is the excuse policymakers and regulators have for not making it incredibly easy to deal with bad debt in an orderly way?
Opacity. It is opacity that allowed the policymakers to choose to “foam the runway” as it made it impossible for the market to exert discipline to write-down this debt.
Opacity also allowed the policymakers to take a pass on orderly handling of bad debt. I am aware the FDIC and its sister regulators in other countries have been putting in place a methodology for unwinding a Too Big to Fail bank. However, so long as central banks continue to say this Too Big to Fail banks can survive financial armageddon, it will never be used. Why? Regulators will always think taking over a bank this size will make a financial crisis worse. Also, there is a moral obligation to protect investors who trusted the government’s assessment of the bank’s solvency.
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