A Bank Bailout That Works (Page 4)

Editor's Note: An earlier version of this essay erroneously stated that Sen. Christopher Dodd supports bank nationalization. In fact, Dodd has said he does not welcome nationalization, but "we may end up having to do that."

Gradually America is realizing that we must do something--now. We already have a framework for dealing with banks whose capital is inadequate. We should use it, and quickly, with perhaps some modifications to take care of the unusual nature of today's problems. There are several ways we can proceed. One innovative proposal (variants of which have been floated by Willem Buiter at the London School of Economics and by George Soros) entails the creation of a Good Bank. Rather than dump the bad assets on the government, we would strip out the good assets--those that can be easily priced. If the value of claims by depositors and other claims that we decide need to be protected is less than the value of the assets, then the government would write a check to the Old Bank (we could call it the Bad Bank). If the reverse is true, then the government would have a senior claim on the Old Bank. In normal times, it would be easy to recapitalize the Good Bank privately. These are not normal times, so the government might have to run the bank for a while.

Meanwhile, the Old Bank would be left with the task of disposing of its toxic assets as best it can. Because the Old Bank's capital is inadequate, it couldn't take deposits, unless it found enough capital privately to recapitalize itself. How much shareholders and bondholders got would depend on how well management did in disposing of these assets--and how well they did in ensuring that management didn't overpay itself.

The Good Bank proposal has the advantage of avoiding the N-word: nationalization. Some believe a more polite term, "conservatorship" as it was called in the case of Fannie Mae, may be more palatable. It should be clear, though, that whatever it is called, the Good Bank proposal entails little more than playing by longstanding rules, a variant of standard practices to deal with firms whose liabilities exceed their assets.

Those who say the government cannot be trusted to allocate capital efficiently sound unconvincing these days. After all, it's not as though the private sector did a very good job. No peacetime government has wasted resources on the scale of America's private financial system. Wall Street's incentives structures were designed to encourage shortsighted and excessively risky behavior. The bankers were supposed to understand risk, but they did not understand the most elementary principles of information asymmetry, risk correlation and fat-tailed distributions. Most of them, while they may have been ethically challenged, were really guided in their behavior by the perverse incentives they championed. The result was that they did not even serve their shareholders well; from 2004 to 2008, net profits of many of the major banks were negative.

There is every reason to believe that a temporarily nationalized bank will behave much better--even if most of the employees are still the same--simply because we will have changed the perverse incentives. Besides, a government-run bank might spend some time and money teaching its employees about risk management, good lending practices, social responsibility and ethics. The experience elsewhere, including in the Scandinavian countries, shows that the whole process can be done well--and when the economy is eventually restored to prosperity, the profitable banks can be returned to the private sector. What is required is not rocket science. Banks simply need to get back to what they were supposed to do: lending money, on a prudent basis, to businesses and households, based not just on collateral but on a good assessment of the use to which borrowers will put the money and their ability to repay it.

Meanwhile, there needs to be an orderly plan for disposing of the old bad assets. There is no magic in moving them around from one owner to another. In some countries, government agencies (often hiring private subcontractors) have done a good job of selling off the assets. Other countries (including some hit in the East Asia crisis a decade ago) have had an unfortunate experience, bringing in investment banks and hedge funds to dispose of their assets. These institutions simply held them for the short time it took the economy to recover and made a huge capital gain at the expense of the country's taxpayers. To add insult to injury, some even took advantage of tax havens to avoid paying taxes on those huge profits. These experiences suggest caution in turning to hedge funds and other investment firms.

Every downturn comes to an end. Eventually we will be able to sell the restructured banks at a good price--though, one hopes, not one based on the irrational exuberant expectation of another financial bubble. The notion that we will make a profit from the bailouts--which the financial sector tried to convince us were "investments"--seems to have dropped from public discourse. But at least we can use the proceeds of the eventual sale of the restructured banks to pay down the huge deficit that this financial debacle will have brought onto our nation.

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