Who should pay to resolve the banking crisis?

January 22, 2009

The blogosphere is awash with opinions about whether banks should be nationalized, and whether an aggregator bank to hold bad debt is a good idea. Much of the heated debate about the mechanics of a rescue is about the technical details of the rescue, devoting little time to the fundamental normative question : who should shoulder the debt losses, and in what proportion? Once that question has been settled, many mechanisms exist to achieve the desired distribution of losses.

Losses suffered by the banks can be apportioned among the following stakeholders : taxpayers, bank management, shareholders, debt-holders, and depositors. For taxpayers and depositors, the answer is clear cut. Taxpayers will shoulder the majority of the losses because the government is the only entity with sufficient funds to fill the hole. Depositors should not sustain any losses whatsoever because they were not at fault, and sharing losses with depositors will cause an immediate bank run on all banks. As for management, while the public overwhelmingly favors punishing management, perhaps by firing current management and clawing back compensation paid to past management, the actual financial impact on the banking crisis will be negligible regardless of the course of action. The money that can be recouped from management is miniscule compared to the scope of the problem. The last two classes of stakeholders poses the most acute moral questions. Are shareholders responsible for the crisis because of the pressure they exerted on management for profits? Should debt-holders have performed better due diligence before lending money to banks? Should they be completely wiped out to reinstate moral hazard, or will completely crushing them scare private investors away from bank stock and debt at the precise time when banks need capital? There are no easy or correct answers to these questions, as they are essentially value judgements. Nevertheless, serious debate about these questions should be undertaken.

Once it has been decided how to divide the losses, many mechanisms exist to do so. Outright nationalization will completely wipe out shareholders, with the option of also causing pain on debt-holders should the government choose not to honor unsecured debt. An aggregator bank that purchases bad debt at prices far above market prices will essentially preserve both shareholders and debt-holders at the expense of taxpayers. Alternatively, the aggregator bank can demand a large haircut to acquire the bad debt, essentially socking it to both shareholders and debt-holders, or demand warrants or senior debt, which will again harm shareholders and debt-holders respectively. The possibilities and variations are almost endless. My gut feeling is that the Obama administration will go with the aggregator bank approach, because that is the most flexible, allowing the government to purchase various amounts of debt and inflict various levels of pain on stakeholders.

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Read more on Banking at Wikinvest

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