Restructuring Debt Key to Quickly Ending Financial Crisis
Regular readers know the global financial system is designed to support the Swedish Model for responding to a financial crisis. Under the Swedish Model, losses on the bad debt in the financial system are recognized upfront. This minimizes the damage to the real economy caused by the crisis.
Regular readers also know the Committee to Save the Banks rejected the Swedish Model in favor of the Japanese Model. Under this model, banks are saved at all costs. One way of doing this is to “foam the runway” so banks recognize the losses on their bad debt exposures over a very long, say infinite, time horizon. This undermines the real economy by continuing to burden it with debt service payments (cash could otherwise be used for consumption) as well as the creation of zombie firms (firms that cannot repay their debt, but whose continued existence undermines the profitability of their industry).
In the Financial Times’ Martin Sandbu’s own words:
I want to draw the opposite lesson and depart from the consensus … Everything we have seen since the crisis shows that we need to be more, not less, willing to “resolve” financial institutions.
Shorter: adopt the Swedish Model and require losses on bad debt to be recognize.
The problem with Lehman was not the refusal to bail it out, but the failure to manage the fallout of the bankruptcy. In particular, the normal bankruptcy process is far too slow for a bank, let alone a systemic institution as Lehman was.
So the question is really what could have been done with Lehman that would have allowed it to continue operating until such time as it could have been wound down without disrupting the global financial system. [Answer: let it convert to a bank holding company. Explained in detail below.]
Why is this important?
The imperative in a financial crisis is to keep the essential functions of financial intermediaries active, by direct state intervention when necessary. That means, in extremis, temporarily taking control — nationalising — relevant financial institutions and maintaining their essential operations.
For the last decade, I have pointed out policymakers in the 1930s faced exactly the same problem: how to let insolvent banks continue operating and supporting the real economy while at the same time having them recognize their losses.
These policymakers came up with an ingenious solution. They combined deposit insurance with a central bank’s lender of last resort capabilities. This combination allows insolvent banks to operate indefinitely until such time as the regulators closed them down.
Why?
Deposit insurance makes the taxpayers an insolvent bank’s silent equity partner. With the taxpayers as the silent equity partner, the central bank can act as a lender of last resort to the insolvent bank and guarantee it always has access to the funds it needs.
Since the insolvent bank can operate indefinitely, there is no barrier to its recognizing the losses on its bad loans and investments.
Has there ever been a time when a country has forced it large banks to recognize their losses in response to a financial crisis?
It was first done in the US in 1933. Subsequently, it was done in Sweden in the 1990s and in Iceland in 2008/2009. Every time it has been done, the real economy has quickly recovered.
US policymakers should have let Lehman convert to a bank holding company with the understanding it would have to recognize the losses on its bad loans and investments upfront.
As Mr. Sandbu points out:
Inventing new policy in the middle of a crisis is never ideal.
It is particularly not ideal when it is totally unnecessary and it overrides how the financial system is designed to contain the damage from a financial crisis.
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