How should large-scale systemic failures of a country’s financial system be addressed? Nobody wants to bail out banks that make bad decisions. But to save a financial system from collapse requires preventing all banks from failing at the same time. We need a way to bail out good banks but allow bad banks to fail. But how can we distinguish good banks from bad?

When markets panic, as they did in 1929 and again in 2008, supporting the financial system is essential. The alternative would be a 1930’s-style depression. But that does not mean that we should bail out individual banks.

Recent economic history is replete with examples of financial crises: the US in the late 1980s; Sweden, Finland, and Norway in 1992; Japan in 1998; and much of the world economy in 2008. The ways these crises were handled offer important lessons.

In 1992, Sweden’s central bank, the Riksbank, allowed private bank equity holders to be wiped out, but it rescued depositors and creditors by buying up risky assets of failing institutions. Sweden recovered.

Japan recapitalised its banks in 1998, but did not wipe out equity holders. Because insolvent banks were kept alive through government bailouts and guarantees, Japan provided the wrong incentives to its financial institutions. As a result, Japan never fully recovered from its recession.
So the lesson is that we must allow equity holders to lose money sometimes in order to maintain a healthy financial system.

An important role of central banks is to provide cash to potentially insolvent banks in times of panic, when all other sources of capital dry up. The central bank is the “lender of last resort”. But if bankers know that they will be bailed out in bad times, they have an incentive to make risky loans. These loans earn the banks a high return when the economy is strong, but are protected from losses by government bailouts when the economy weakens.

In 2007, Lehman Brothers, AIG, and most other players in the financial markets were earning huge returns by trading derivatives backed by very risky mortgages. When US housing prices fell, some of these players should have gone bankrupt. But when the Federal Reserve allowed Lehman Brothers to fail in September of 2008, there was widespread panic, leading the Fed to intervene to prevent the collapse of every other major player. How could things have been managed differently?
As Simon Johnson suggests in his book 13 Bankers, we should break up the mega-banks into smaller parts that can comfortably be allowed to fail. But it is not enough to have many small banks. We must also find a way to support the system as a whole.

I propose a new policy solution that would support the whole but not the parts. Central banks should put a floor under the value of a country’s banking system by committing to buy shares in an index fund of bank stocks at a predetermined price. This price commitment would take effect in times of financial panic. By guaranteeing to buy shares of a mutual fund, the central bank would provide an incentive for private investors to channel money to the stronger parts of the banking system while allowing the weaker parts to fail.

The index fund would be similar to the ones held by so many workers today in private pension plans. Individual banks would rise or fall in importance based on their value relative to the market index of all banks in the fund. By offering to buy shares in the mutual fund at a minimum preset price, the central bank would provide a way of channelling funds into the financial system in times of crisis. Although this plan would prop up the value of the financial system as a whole, it would still allow market forces to determine relative share prices of individual banks.

If this structure had been in place in the US in 2008, when house prices collapsed, banks that held large portfolios of underperforming toxic assets would have started to drag down the value of the index fund. But these banks also would have fallen in importance in the total index. The Fed’s commitment to buy shares of the mutual fund at a preset price would have caused investors to put new capital into the stronger banks to take advantage of the central bank’s price support.

This scheme for recapitalising banks has three advantages over others that have been suggested by economists and politicians. First, it does not require government regulators to decide how much individual assets are worth, because private markets value toxic assets.

Second, it removes the incentive for banks to make bad decisions. By allowing bad banks to fail, it solves the moral-hazard problem.

Finally, by offering to buy shares in a mutual fund of bank stocks, the central bank gives private investors the incentive and the confidence to recapitalise the banking system. This plan would allow us to bail out good banks and allow bad banks to fail – without costing the taxpayer a penny. — Project Syndicate

Roger E A Farmer is Distinguished Professor of Economics at UCLA and the author of two new books on the current global economic crisis: How the Economy Works: Confidence, Crashes, and Self-Fulfilling Prophecies and Expectations, Employment, and Prices

This article appeared in Forum page of The Edge Malaysia, Issue 812, June 28-July 4, 2010