Are Banks Too Big to Save?

An excellent comment in the Financial Times by Wolfgang Munchau discusses how the gold standard for handling banking crises, the Swedish model, would take even more discipline to implement in the US and how we are dong the reverse of what is needed.It is a levelheaded analysis which stands in stunning contrast with a bit of advocacy masquerading as economics from Larry Summers in the same section of the FT today.

But in the course of his discussion, Munchau makes the observation that none have dared face up to: the financial system is too big for governments to rescue. We’ve given the weaker form of that argument: the US, or even the US plus all the world’s central banks, cannot keep a massive, multi-market asset bubble from deflating. But not only can the current financial system not be saved, it shouldn’t be saved. The debt binge means it is at an unsupportable, bloated scale. It needs to be trimmed down to a more viable size, and only that level should get government support.

From Munchau:

Last week’s dramatic events hold two transatlantic lessons in opposite directions, one from Europe to the US and one the other way. The first comes from Sweden, which suffered its own financial crisis during the early 1990s. The Swedish lesson is that bank bail-outs should be handled conservatively and should come in the form of direct capital injections.

As in the US, the Swedish financial crisis was also preceded by a property bubble, which was pricked by a rise in real interest rates. Severe stress in the financial system and the economy were to follow. In each of the three years 1991, 1992 and 1993 Swedish gross domestic product fell in real terms, at an accumulated rate of about 5 per cent.

In response, the Swedish government set up an agency to recapitalise the financial sector. Bank shareholders were not compensated. But the Swedish government did not bail out all banks, only a subset. They used a microeconomic model to determine which of the banks had a chance to survive, and which did not. Those that did not were liquidated or merged. And those that were bailed out had to write off their bad debts first. All depositors were covered by an explicit government promise of compensation. The goal was to minimise the cost to the taxpayer, and it succeeded. It turned out as one of history’s most successful financial system bail-outs.

There are naturally important differences between the situation in Sweden then and the US today. The most important is that our most recent bubbles surpassed anything we have ever seen before. We do not only have to deal with a bursting property bubble, but also with the huge leverage effects through the credit markets.

The US has a much bigger problem today than Sweden did then. Like Sweden, the US needs to shrink its financial sector before saving it. The difference is that the US needs to shrink it a lot more, and wants to shrink it a lot less.

In this context, Daniel Gros and Stefano Micossi last week made an astute observation on these pages: several European banks have become so large that their governments could no longer save them. Banks once considered as too big to fail have become too big to save. Unlike the German government, the US administration is in a position to save its largest bank, but is not big enough to save its entire financial system.

The problem with the original Paulson plan is not merely the lack of direct equity injections. By purchasing junk securities at above market prices, the plan is indiscriminate in that the bail-out would apply to each bank with junk debt on its balance sheet. It would recapitalise the financial sector in its current form, an exercise that is simultaneously unfair and futile. The new package, if finally implemented, is not going to resolve that fundamental dilemma either.

Without a contraction in the financial sector, the US administration risks a debt explosion, and a sudden withdrawal of foreign financial investors. This is the other big catastrophe looming large in the background. We are facing two big tail risks from different ends. Failing to rescue the banking system could lead to a depression. But so could a rescue if it produced macroeconomic instability.

What about the lesson from the US to Europe? It is that bank bail-outs require a swift political response. When you look at the eurozone, it is not clear at all where this response could come from.

By the time European ministers have travelled for a meeting in Brussels, let alone reached or implemented a decision, the financial markets would have long melted….

While the Americans need a better rescue plan, the Europeans need a lot more: a system that could produce a rescue plan in the first place.

Munchau may be being a bit hard on the EU. It managed, contrary to expectations, to put together a package for Fortis, and Willem Buiter hails the accomplishment.

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  1. Dean

    If all misfortunes were laid in one common heap whence everyone must take an equal portion, most people would be contented to take their own and depart.

    I do nothing but go about persuading you all, old and young alike, not to take thought for your persons or your properties, but and chiefly to care about the greatest improvement of the soul. I tell you that virtue is not given by money, but that from virtue comes money and every other good of man, public as well as private. This is my teaching, and if this is the doctrine which corrupts the youth, I am a mischievous person.

    Socrates, quoted by Plato, ‘The Death of Socrates’
    Greek philosopher in Athens (469 BC – 399 BC)

  2. Matt Dubuque

    Matt Dubuque

    A couple of points about the Swedish model may prove helpful. I have not previously embraced that model (even though it was wildly popular among bloggers) because it was by no means clear how it would be scaled up.

    Note that Jan Kvarnstom, a former CEO of Securum (which was the agency in charge of all this) has stated that:

    “You have to get your hands on the underlying assets quickly, get control over the cash flow and MANAGE THE ASSETS TO ADD VALUE TO THEM. It is very important to prove your professional credentials in the market and NOT to be seen simply as an asset dump.”

    The Swedes were very talented asset managers. That is how they saved money to the Swedish taxpayers. ADDING value.

    That approach would have to be massively scaled up to succeed in the USA. How we would obtain the thousands of brilliant asset managers, actively ADDING value to do this is by no means clear to me.

    Matt Dubuque

  3. dearieme

    Do you mean, Matt, that you reckon that you have fewer “very talented asset managers” per head of population than the Swedes? Is that plausibe? The Swedes are blondes.

  4. François

    By the time European ministers have travelled for a meeting in Brussels, let alone reached or implemented a decision, the financial markets would have long melted.

    I disagree here. Governments of the Eurozone members have direct access to international debt. I’d challlenge the ability of Italy and a couple of others (Greece?) to cope with massive desintegration of their banking system in view of their weak position. But this judgment is wrong for most of EC members. IMHO…

    And Europe is much more at ease on those issues than Britain or the US. Ideologically speaking

  5. Francois

    “Like Sweden, the US needs to shrink its financial sector before saving it. The difference is that the US needs to shrink it a lot more, and wants to shrink it a lot less.”

    Correction: The powers that be in the US _need_ the financial sector to remain big enough to keep the flow of campaign contributions coming their way.

    Just take a look at which sector of the economy are the biggest donors to DC.

    This also explains why the “bailout” plan is designed the way it is now.

    Plus ca change…

  6. Independent Accountant

    I can’t even read Larry Summers stuff anymore. Summers is a smart guy and knows he is putting out garbage.

  7. Amnon Portugaly

    The Scandinavian banking crises, in Sweden and Norway in 1990s are an excellent models of how a banking crisis should be resolved.
    Key features of the Norwegian banking crisis resolution:
    • Private solutions were explored before the government intervened.
    • Share capital was written down to zero before committing public funds.
    • The government acted swiftly to limit contagion, but did not provide a blanket guarantee.
    • Liquidity support was given to illiquid, but solvent institutions.
    • The government did not use an asset management company – as the other Nordic countries did later on.

    A Norwegian perspective on banking crisis resolution by Kristin Gulbransen

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