Submitted by Edward Harrison of the site Credit Writedowns
Edward Harrison here. I wanted to begin my series of posts here on naked capitalism with my thoughts regarding the policy response to the banking crisis in the United States. I believe Yves would agree that the response to date has lacked the necessary urgency to move us forward in a sustainable way and that, consequently, downside risks remain for economic growth and asset markets.
In any banking crisis, the central question always is: which financial institutions now operating are insolvent, how can we identify them and remove them from the system, and how can we recapitalize the remaining institutions in a way that restores confidence to the system generally? Therefore, any response by policy makers must address three separate issues:
- Confidence in the system. This is the first question to be addressed because no fractional reserve banking system can function without confidence in its integrity. Is Citigroup going to be nationalized? Are the regionals sitting on massive commercial real estate time bombs? Does Wells Fargo have a fatally large exposure to California-based HELOCs? If BofA goes bust will I get my money back at the ATM? No one knows the answer to these questions definitively. As a result, each and every institution in America is subject to suspicion about its solvency by depositors, debt holders, commercial paper investors, and transaction counterparties. The whole system comes under a cloud. In short, doubt breeds fear and fear creates systemic risk.
- Identification of insolvent institutions. This is the tricky bit for a number of reasons. First, I should note that Warren Buffett has said Wells Fargo has a pre-tax earnings power of $40 billion. That is enormous. While one should be suspicious whether Buffett is talking his own book, it points out the fact that any bank can ‘earn its way out of insolvency’ if given enough time. Nationalization is but one option. (John Hempton has noted that the Japanese banks actually did not have the benefit of time as their spread margin was so small due to the infamous zero-interest rate policy – you need a steep yield curve). But, ultimately, it is liquidity that is at issue for many bankrupt financial institutions – a loss of depositor or creditor faith. Their credit lines are pulled (Bear Stearns) or bank customers flee (Northern Rock). So, when we ask whether an institution is insolvent or bankrupt, it is a trick question because many failed financial institutions suffer a lack of liquidity — a circumstance which presages insolvency (see my take on this issue here). Identifying whether an institution is fundamentally insolvent depends crucially on the true value of its asset base as well as future loan losses and credit writedowns.
- Recapitalization of solvent companies. Once one determines whether a financial institution is insolvent, the remaining solvent institutions might still be so fragile as to succumb to liquidity pressures. They must be adequately recapitalized in order to preserve confidence in the system as a whole. How one goes about doing so is less important than doing so. Moreover, it is crucial that government not recapitalize insolvent institutions lest they be confused with solvent entities, re-creating the loss of confidence which created the panic and crisis to begin with.