Wednesday, November 12, 2008

"What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. "

Here's an interesting exchange involving a few of my favorite people, Felix Salmon, Willem Buiter, and John Hempton. Let's begin here:

"There is a wonderful (simply wonderful)
paper by Willem Buiter and Anne Siebert on the Icelandic banking crisis.

It’s the sort of paper that puts the lie to the line “nobody expects the Spanish Inquisition” because the core part of the paper was written – under contract – to the Icelandic Central Bank. All agreed that the contents were “too hot” and the academic authors agreed to secrecy.

Now that the worst has happened there is less need for secrecy so the paper has been published along with policy prescriptions for Iceland.

Ok – well and good.

Their explanation was that it doesn’t matter whether the Icelandic banks were solvent or insolvent – there was a simple problem that the banks were large compared to the Icelandic economy and the governments could not conceivably bail them out. As a result a run on one of them would collapse them all.

I will express an opinion on one – and one only. I think Kaupthing – which was by far the most aggressive purchaser of foreign assets – was probably insolvent.

Anyway the lesson was that a country could not afford to have banks whose liquidity they could not guarantee in a run. If the banks were so big you could not guarantee the liquidity then the banks were set up to fail."

Somehow, this seems obvious, but it's not.

"Of course there is one remaining country with banks that are large-relative-to-the-economy – and that is the UK. RBOS and Barclays are both enormous and - at best opaque.

Now do American taxpayers want to pick up UBS or Barclays? I don’t think in the end they will have any choice. The banks will fail or they won’t. And if they fail – well I hate to say it – but the new administration will be stuck with it. I guess UBS will lose its tax avoidance business in the process… and a few American rich folk can help pay for it all with their back taxes... unfortunately the risks to the system are bigger than that..."

Wait a minute. Are we implicitly agreeing to guarantee the whole world?

Now Felix Salmon:

"Richard Baldwin of VoxEU gives us a sneak preview of a new article by Jon Danielsson:

In this crisis, the strength of a bank's balance sheet is of little consequence. What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. Therefore, the size of the state relative to the size of the banks becomes the crucial factor. If the banks become too big to save, their failure becomes a self-fulfilling prophecy.

This seems right to me. And also very scary, because of one country: Switzerland."

Here we go again with implicit and explicit guarantees.

"This could be the first make-or-break economic issue to face Barack Obama: if it came to it, would Treasury bail out UBS? I'm sure it would try to get European governments to pitch in too, and the Swiss, of course, to the extent that they can. But I'm sure I'm not the only person praying that UBS never comes close enough to the edge that we have to find out."

Here's my reply:

Posted: Nov 12 2008 10:03am ET
"What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity."

Can we all agree,at least, that these guarantees become explicit and clearly defined? This is beginning to sound to me like Dr. Strangelove:

Strangelove explains the principles behind the Doomsday Device, which he says is "simple to understand... credible and convincing." He also points out that a Doomsday Device kept secret has no value as a deterrent; the Soviet Ambassador admits that his government had installed it a few days before they were going to announce it publicly to the world, because Kissoff "likes surprises".

"But I'm sure I'm not the only person praying that UBS never comes close enough to the edge that we have to find out."

Um, have we implicitly guaranteed the entire banking planet?


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