Uncharted Territory

February 13, 2009

Good Banks, Bad Banks and Nouriel Roubini

Filed under: Credit crisis, Economics, Housing market — Tim Joslin @ 12:22 pm

A number of pundits are being reported in the press, urging Governments, principally in the US and the UK, to nationalise their banks.  Some dress this up by suggesting the establishment of “good banks” or “bad banks”, but, I suggest, this comes to much the same thing.  Such advice is based on a number of premises, all of which are potentially unsound. These premises include the ideas that:

1. It is desirable for the overall level of lending and in particular mortgage lending to recover to its pre-crunch levels.

2. There are vast amounts of further losses still to surface.

3. Banks with large amounts of potentially bad debt on their books are a drag on an economy.

4. Recapitalisation of the banking system in Sweden and Japan not only allowed these economies to recover, but was beneficial in the long run.

Good banks, bad banks and nationalisation

Before addressing these fundamental premises, let’s just consider what the difference is between good banks, bad banks and temporary nationalisation.  Very little, is the answer, it seems to me, except that the last may be less disruptive to the organisations, but wipes out shareholders.

There appears to be a common misconception that governments can avoid liability for losses on bank assets by separating them off into a separate entity (or entities).  This is very unlikely to be the case.  I simply do not see how a Government could create a profitable business and an unprofitable one and then let the unprofitable one fail!  The lawsuits would be endless.

I’ve spent a large part of my working life implementing IT systems designed to reduce the risk of a systemic failure caused by problems at one financial institution.  I’m therefore somewhat disappointed that Lehman’s was allowed to fail in a disorderly fashion.  If the economic commentariat are agreed on one thing, it’s that Lehman’s bankruptcy should have been avoided at all costs, because of the knock-on effects.  Millions unemployed around the world simply to prove a point?  Not a good trade, was it?  Whether they create good banks, bad banks or maintain the existing industry structure, governments simply cannot allow another large financial institution to fail.  Governments are therefore responsible for the net losses of any institution.  Since more institutions are likely to have net losses if good assets are separated from bad, simply separating the two would be a very expensive exercise.

Nationalising banks may seem attractive.  But why bother?  Banks can and have been recapitalised short of nationalisation.  In the UK, there is some talk of the state lending directly to consumers.  I’ve long since given up expecting HMG to respect the money I pay them in tax, but letting the jokers who run local government make unaccountable lending decisions would be criminal.

There is nothing to stop new entrants offering loans in the UK.  The Government could even make it clear that they would be treated exactly like other banks in terms of receiving state support.  If the existing banks are so hamstrung by bad debts, why can’t Sainsbury’s Bank and Virgin Bank borrow on the money markets to lend for mortgages?  Except, as discussed yesterday, the self-defeating position the Government has taken that money markets are a bad thing.  Will local councils take deposits to back up the mortgage lending they propose to undertake?  Doesn’t sound like it.

There is a view that bank shareholders should be “punished”.  This deserves a whole post in itself, so I’ll try to be brief.  I wrote some time ago that moral hazard is “a special case of expectations”.  Wiping out shareholders for the sake of it would create an expectation of similar behaviour in future.  Shareholders would take even less of a long-term view.  They would tend to “take the money and run”.  They’d be happy to profit from the next lending boom, but would sell out at the first sign of trouble.  There was an interesting exchange in the Treasury Select Committee grilling of UK bankers this week.  Barclay’s Varley (sorry, I keep thinking his first name must be Reg, now I can’t remember what it actually is!) noted that shareholders tend to sell if they feel a company is being mismanaged.  It’s already the case that most don’t hang around to try to improve corporate governance.  The MP who asked the question was surprised.  Unfortunately, Varley didn’t press the point, since the MPs were there to impress their view on the bankers, not actually learn anything.  No, wiping out shareholders for the sake of it would be counterproductive.  They no longer, in general, have an active role in managing companies, if they ever did.  If we’re worried about moral hazard, we should also be worried about creating a perception of political risk in the UK (or wherever).  The mobility of equity capital suggests that political risk is the danger that applies to treatment of shareholders, not moral hazard.

Premise 1: Should we be resuming lending anyway?

James Crosby has exited stage left now, so perhaps we should have another look at the conclusions of his report on mortgage lending.  In blaming the details of bank management, the authorities are missing the wood for the trees.  House prices were too high.  The problem, in both the UK and the US, was that house prices rose too far, NOT that they’re now falling.  That is merely a symptom.  I feel like writing whole sentences in this paragraph in uppercase.  Bold.

Why on Earth would we want mortgage lending to return to its bubble-year level?  We need to let house prices fall.  We should aim for other forms of lending to increase to return the economy to growth.

If economies were growing as a result of house-price bubbles and, in some but not all cases, building booms, then this has now been shown to be unsustainable.  Such economies need to rebalance, which may mean a period of slower growth as other sectors of the economy catch up from a lower base.

A slight digression: note that the UK is in the fortunate position of being able to build houses.  As I’ve already spelt out, the Government should consider what needs to be done to stimulate lending for house-building.

Let’s just simplify the position and consider what must logically be the case, that is, that some banks have lent more to the housing market, and others to businesses.  The former will likely (at least once we start to pull out of recession) have more chronic bad debts.  These loans will prove to be less profitable than they thought.  If they are thus unable to attract fresh capital, funds will flow instead to those banks focused on lending to business.

The Government should therefore not be demanding the resumption of mortgage lending.  It should simply be allowing the banks to make their own lending decisions on the basis of what is likely to be profitable in future.

Premise 2: There are vast amounts of losses still to surface

Here’s what one of the jeremiahs, Martin Wolf, wrote in the FT a few days ago:

“But, [it is argued] the rest of the world will strike back: as the world economy implodes, huge losses abroad – on sovereign, housing and corporate debt – will surely fall on US institutions, with dire effects.  Personally, I have little doubt that [this] view is correct and, as the world economy deteriorates, will become ever more so.”

But the strategy is to try to stop the world economy deteriorating further!  If it “implodes”, then, by definition, we’re all toast!  That’s why Governments around the world are spending so much on fiscal stimuli.  Declaring most or all banks insolvent now would be to shut the stable door before putting the horse inside!  More specifically, are we really expecting sovereign debt defaults?  As Wolf himself argues, the countries likely to be vulnerable in a crisis have built up huge foreign currency positions.  The IMF has helped several countries, but there’s no reason to expect defaults in these or any others.  Especially as we are now so alert to the problem.

There may well be further losses if the global economy responds to the intensive care it is receiving, but at least some of the scaremongering is overdone.  And what really matters is whether bad debts have to be written off faster than individual institutions can profit from good lending or raise fresh capital, as Barclays has shown.

Premise 3: Banks with bad debts are a drag on the economy

I think I’ve moreorless covered this already.

What is this idea of “zombie” banks?  Carrying potentially bad debts is normal for banks.

Banks are only intermediaries.  If money wants to be lent, it will be, one way or another.  Other institutions – overseas banks, SWFs lending directly, or even private equity – will take up the slack. In fact, the “shadow banking system” was in large part responsible for mediating lending during the boom years.

I repeat, resuming indiscriminate lending is NOT a solution.  If overseas holders of sterling (or dollars) can’t see a decent return from assets denominated in those currencies, then they should sell the currency, which would be wholly a good thing, allowing global trade imbalances to correct themselves.

Premise 4: The Swedish and Japanese models

I’m deeply sceptical about these models for different reasons.

The Swedish banks were famously nationalised in the 1990s as a result of bad lending during a property boom.  No sooner had they recovered, I note, than they lent into another housing boom – in the Baltics!  Take the money and run!  Though they had learnt, perhaps, that there was a lack of profitable lending opportunities in Sweden itself.

Japanese growth is held to have been sluggish during their “Lost Decade”, and only briefly better since.  But their banks aren’t the cause of this.  Until Japanese property values declined from their ridiculous levels in the late 1980s there was a dearth of profitable lending opportunities in Japan.  In fact, since Japan has fuelled the “carry trade”, there is evidently still a lack of lending opportunities there, compared to overseas (their corporate sector is cash generative – probably!).  Given uneven economic development, especially in Asia, surely the Japanese would be expected to invest abroad?

There may be problems with the role of overseas banks in an economy (that may be the understatement of the week) but nevertheless, the global economy is open.  If one country’s banks do become “zombies” and can’t lend until they’ve rebuilt their capital, foreign banks will step in.  Or at least they will if they perceive profitable lending opportunities relative to their home market or other overseas domains.

Conclusion

In terms of the structure of the banking system, governments in the UK, US and elsewhere are following the correct strategy of “muddling through”.

But they should be more focused on ensuring that there are no obstacles to lending to business.  This is best achieved by reducing the pressure on banks to make fresh mortgage lending.

The UK Government, mindful of the voters of Middle England, are in denial about the housing bubble. The Times reported yesterday that:

“First-time buyers typically had a deposit of 22 per cent in December, the highest proportion in 34 years of available data.  The average first-time buyer borrowed 3.1 times their income…”

Since only a small proportion of potential first-time buyers can find 22% deposits (+ other purchase costs) and earn 1/3 of the average cost of the first-time home (less 22%), house prices have a long way to fall yet.  And an average of 3.1x income is still too high – the maximum loans normally granted back in the 1980s were 3x income or 2.5x joint, if memory serves.  Interest rates won’t stay this low forever, and the longer they do, the more they will rebound in a couple of years.

The Government should, for once, tell the public something they don’t want to hear – that house prices need to come down, and stay down, relative to wages, at least at the bottom end of the market.

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3 Comments »

  1. […] Credit crisis, Economics — Tim Joslin @ 10:40 am I’ve received a comment via email on my last post including the claim that: “The good bank model does not necessarily interfere with the […]

    Pingback by New banks vs “good” banks « Uncharted Territory — February 14, 2009 @ 10:40 am

  2. Nassim Taleb spoke out in Davos about banks and the moral hazard of bailouts.

    He and Nouriel Roubini were both interviewed at CNBC recently, but soundbite journalists are incapable of handling their views sadly.

    Zimbabwe citizens know very well what kinds of horrors hyperinflation can bring, but this kind of phenomenon is considered remote from occuring elsewhere.

    Glenn Beck’s hockey stick makes me think again.

    Comment by Mark T. Market — February 27, 2009 @ 4:07 pm

  3. I think the failure of Lehman’s corporate governance was evinced in back in the summer of 2008 when the top execs viewed the market rather than the stockholders as “demanding that we hold ourselves accountable,” according to Skip McGee. I’ve just finished a blog post arging that while self-accountability is a laudable goal, we can’t (or shouldn’t) rely on it. In fact, “holding ourselves accountable” suggests the absence of accountability through corporate governance.

    Comment by euandus — October 23, 2009 @ 1:06 am


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