14 March 2016

PIIE: A ticking time bomb: TLAC and other attempts to privatise bank bail-outs

Proponents of bail-in securities argue that knowing the public sector will bail out banks makes them take greater risks. This argument sounds right but begins to unravel on inspection. Most so-called bailouts have left shareholders with little and forced bondholders to suffer a haircut. Central banks try to adhere to the adage that it is the banks that are bailed out, not the bankers. Maybe this could be more explicit and broader. While few CEOs survive, most directors and managers do. Moreover, the alternative to bail-ins is not unconditional bailouts of all and sundry. The best way of protecting taxpayers in the long run is to rely on three familiar, tried and tested elements.

It is to the public sector that it is needed turn to when liquidity dries up, to provide copious quantities of it against reasonable collateral à la Thornton and Bagehot. This will be sufficient for those institutions, who, ex post, have been most prudent and are not overladen with non-performing assets or those that are hard to price. They are few.

The balance of institutions can be broken down into two camps. There are those for whom the environment of risk aversion and their inability to price part of their assets casts a disproportionate shadow over the rest of the institution. The tendency, observed during the current European debt crisis, the Japanese Deflation in the 1990s and the US Savings and Loans debacle in the late 1980s, will be for these institutions to sell-off their liquid assets to meet current liabilities and to hang on, often with regulatory forbearance, to the hard-to-price assets in the hope that the risk-aversion will lift or economic conditions will improve. While this allows them to survive, their balance sheets are locked up. These “Zombie banks” are unable to respond to any demand for loans and greet every upturn with the sale of assets. They end up acting as weight on the recovery. The tried and tested solution to this group is a “Bad bank” that purchases these assets at, say a 33% discount to their historic cost, with the potential of returning any residual profits to the banks after the public-sector has recouped all of its outlays. Compared to unrealistic pre-crash valuations, shareholders will suffer a loss, but they would likely be relieved by the injection of liquidity and the reduction of uncertainty. The object of the bad bank is to enable the remaining “good” banks to raise private capital and liquidity. It is also to repackage bad assets in a way that would be attractive to those institutions with long-term liabilities that have liquidity to inject. If such institutions are presented with a stabilising environment and assets that are cheap over the long run, they are more likely to buy them and this is the best way of drawing in private-sector liquidity.

To encourage the banks to sell their bad debts to the Bad Bank and not seek to minimise shareholder losses by hanging on, banks should first be required to mark-tomarket those assets for which they do not have long-term funding and raise additional capital. There will be those institutions, which even after selling assets to the Bad Bank, do not have the credibility to survive without public sector support. In these circumstances, the experience of Japan and other banking crises is that serial injections of public capital will prove a costly failure.

Nationalisation is the policy that dare not speak its name, but the cheapest, quickest route for tax payers to deal with these institutions is to temporarily take them over – which often involves an injection of very little capital. The FDIC-style operation would be to remove managers, wipe out shareholders, subordinate creditors and re-organise and re-structure so as to ready these institutions for re-sale to the market place.

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© Peter G Peterson Institute for International Economics