'Good Banks' Are the Cost Effective Way Out of the Financial Crisis - Willem Buiter

'Good Banks' Are the Cost Effective Way Out of the Financial Crisis
We don't have the resources to subsidize all the troubled institutions.

By WILLEM H. BUITER

Treasury Secretary Tim Geithner's bank rescue -- the Financial Stability Plan (FSP) -- has been poorly received by the markets. My proposal last month to create brand new "good banks" with the limited taxpayer resources available is the best solution to the crisis.

One reason the Geithner plan has been poorly received is that the money isn't there to recapitalize U.S. banks as a whole. Mr. Geithner has only $350 billion, what's left of the original $700 billion in the previous administration's Troubled Asset Relief Program. That's nowhere near enough to get Mr. Geithner's proposed Public-Private Investment Fund going on any significant scale. The scale of this investment fund -- $500 billion-$1 trillion -- is an empty wish unless the Treasury convinces the Congress to provide substantial additional resources to guarantee the toxic assets to be valued and bought by private investors.

Moreover, Mr. Geithner's Consumer and Business Lending Initiative only puts up one dollar of Treasury money as credit protection for every $10 dollars of Fed lending, hoping that any losses will not exceed 10% of the amount lent by the Fed (up to $1 trillion). This leverage means that the Federal Reserve system has in effect become a branch of the Treasury.

The truth is that the federal government has little fiscal spare capacity. States and municipalities have, at best, none. With the fiscal boost provided by the stimulus legislation ($787 billion, or about 5.4% of GDP over two years), the federal deficit could easily rise to 12% or even 14% of GDP for the next two years. These are numbers historically associated with banana republics headed for insolvency or hyperinflation.

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Rather than wasting the $1.4 trillion of public funds it would take to restore (according to NYU economist Nouriel Roubini's estimate) the capitalization of the U.S. banking sector to its fall 2008 level, it would be better to use public money to capitalize new banks that don't suffer from an overhang of past bad investments and loans -- and to guarantee new borrowing or new loans and investment by these banks. This "good bank" model achieves this by identifying the systemically important banks that are kept afloat only by past, present and anticipated future public financial support ("bad banks") and taking their banking licenses away.

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The legacy bad banks would not be allowed to make new investments or new loans and would simply manage the inherited stocks of assets in the interest of their owners. They sink or swim on their own. If they fail, their unsecured creditors can figure out what to do with the bad assets.

The good bank approach would not be welcomed by the markets: They price the existing bad banks but not the taxpayer resources saved.

This model is better than full nationalization, because it does not require the government to trust the valuation of toxic assets implicit in the market capitalization of the banks that own them. It only requires the valuation of good assets. It is better as a recession-fighting policy because it stimulates new lending to the real economy more effectively than would an injection of capital into the existing banks, for which old toxic assets act as a tax on new lending.

The good bank model is also better from the point of view of moral hazard because it does not reward past reckless lending and investment. And it is fairer, because the losses on past failed investments are borne by those who made the bad decisions rather than by taxpayers.

Mr. Buiter is professor of European political economy at the London School of Economics and Political Science.

http://online.wsj.com/article/SB123517593808837541.html