"Troubled banks must be allowed a way to fail
Published: May 3 2009 19:01 | Last updated: May 3 2009 19:01
When the financial crisis began to unfold in 2007, US policymakers reacted quickly out of fear that rapidly evolving events would lead to a global economic collapse. In my view, the policy response to this point has been ad hoc, resulting in inequitable outcomes among firms, creditors, and investors. Despite taking a number of actions to stabilise markets and institutions, uncertainty continues and markets remain stressed.
I believe there is an alternative method for addressing this crisis that deals more effectively with the issues we currently face while also considering the long-run consequences of those actions: the implementation of a systematic plan to resolve large, problem financial institutions.
In recent weeks, I have outlined such a resolution framework for dealing with these large, systemically important institutions. Boiled down to its simplest elements, the plan would require those firms seeking government assistance to make the taxpayer senior to all shareholders, with the government determining the circumstances for managers and directors. These firms would be operated by outside individuals with no conflicts involving either the firm or its competitors.
Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and re-privatised as soon as is feasible. This plan is similar to what was done in Sweden in the 1990s and in the US with the failure of Continental Illinois in the 1980s.
This plan has many advantages, including that management and shareholders bear the costs for their actions before taxpayer funds are committed. This process also is equitable across all firms; is similar to what is currently done with smaller banks; and provides a definitive process that should reduce market uncertainty. These are important reasons to implement this kind of resolution process.
In contrast to this suggested approach, the current policy raises a host of issues:
● Certain companies have not been allowed to fail and, as a result, the moral hazard problem has substantially worsened. Capitalism is a process of failure and renewal, and a “too big to fail” policy undermines this renewal and makes the financial system and our economy less efficient.
● So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised in becoming more economically and politically powerful.
● The US government has poured billions of dollars into these firms without a defined resolution process, adding to our national debt. While there will be some repayment, there also will be losses. The longer resolution is postponed, the greater the losses and the larger the debt burden.
● As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role. This is reflected in the fact that its balance sheet continues to swell, which may compromise the independence of the Federal Reserve and make it more difficult to contain inflation in the years to come.
● Failing effectively to resolve these non-viable firms has long-term consequences. We have entrenched these even larger, systemically important, “too big to fail” institutions into the economic system, assuring that past mistakes will be repeated.
Certainly, the approach I suggest for resolving these large firms also is not without substantial cost, but it looks to both the short and long run.
A systematic approach would reduce the uncertainty that has paralysed financial markets; the cost is more measurable and therefre manageable; and there will be fewer adverse consequences compared to the path we are on now.
Because we still have far to go in this crisis, there remains time to define a clear process for resolving large institutional failure. Without one, the consequences will involve a series of short-term events and far more uncertainty for the global economy in the long run.
While I agree that central banks must sometimes take actions affecting the short run, they must keep the long run in focus or risk failing their mission.
The writer is president of the Federal Reserve Bank of Kansas City"