Bail-Ins, Soft Budget Constraints, and Zombie Banking

As everyone now knows, financial intermediation in the past several years was dominated by the shadow banking sector – a network of non-bank financial institutions like SIVs, investment banks and money market mutual funds. The run on this shadow sector in 2008 is what significantly crimped the supply of credit, and continues to hamper the recovery.

One policy response to the collapse in lending and securitization has been to step up various government guarantees and loan purchases. Meanwhile, banks reciprocate by investing in government bonds, which only further pushes down the government’s borrowing costs. Effectively, the government is filing in the missing role of financial intermediation and is further assisting bank recapitalization by ensuring that there is enough cheap money to go around. The fact that banks can borrow at next to zero short-term rates and invest the proceeds in higher-yielding government debt further aids this process.

There are three major issues with this bailout intensive, creditor-friendly approach:

1. One is the issue that lenders (generally) haven’t had to sacrifice. For instance, here is Russ Roberts:

There is seemingly little rhyme or reason to the pattern of government intervention. The government played matchmaker and helped Bear Stearns get married to J. P. Morgan Chase. The government essentially nationalized Fannie and Freddie, placing them into conservatorship, honoring their debts, and funding their ongoing operations through the Federal Reserve. The government bought a large stake in AIG and honored all of its obligations at 100 cents on the dollar. The government funneled money to many commercial banks. Each case seems different. But there is a pattern. Each time, the stockholders in these firms are either wiped out or see their investments reduced to a trivial fraction of what they were before. The bondholders and lenders are left untouched. In every case other than that of Lehman Brothers, bondholders and lenders received everything they were promised: 100 cents on the dollar. [emphasis added]

Those bondholders and lenders made plenty of money on the way up, taking risks. They need to bear those risks on the way down, instead of taxpayers. Bondholders and depositors – who make money as long as things don't go really bad – have the strongest incentives to watch what's going on in terms of risk-taking because they don’t have the unlimited upside of stockholders. But this won't happen if they get bailed out.

2. Two is the zombie banking problem. As Anil Kashyap and others have shown, the refusal to accept banking sector losses in Japan led to a decade-long problem of “zombie banking” in which fundamentally insolvent banks lingered without funding new investment. Saddled with liabilities, American banks, too, are still not lending. This is a recipe for a decade-long slump.

3. Another is the problem of soft budget constraints. This is a concept invented by Janos Kornai initially to examine the sources of inefficiency in Communist Governments. Kornai had the insight that when firms expect to be bailed out after taking large losses, they alter their behavior.

However, Kornai’s logic also works in capitalist economies for all entities – be they hospitals, government-backed mortgage giants, or large banks (or car companies, large insurance companies, airlines, money-markets, states, etc.) – that expect fiscal assistance after chronic failure. Financial institutions armed with a Too-Big-to-Fail guarantee are then virtually certain to take on excessive risk to generate current income, with long-term costs (or risks) borne by the taxpayer.

It may seem odd, but to a certain extent these last two problems balance each other out. Banks may be more reluctant to lend if they retain toxic assets on their books, but may be more willing to lend if they expect to be bailed out (when or if something goes wrong in the future). Allowing these problems to counteract each other (in the short-term) could be intentional for some policymakers – especially those that are eager to find ways to increase lending without forcing banks to recognize the true nature of their losses.

Writing in The Economist, Paul Calello and Wilson Ervin offer an alternate approach – “bail ins”. The idea is to use the bankruptcy process to wipe out shareholders, while recapitalizing banks by converting junior-debt into equity. This proposal has much in common with the “Speed Bankruptcy” proposal by Garett Jones, Ben Klutsey, and Katelyn Christ. The core idea in both cases is to convert the (often, substantial) debt held in major financial institutions into equity quickly, without using taxpayer dollars (A discussion of a related idea – using contingent convertible debt can be found here). After a realistic loss assessment and recapitalization, the idea is that banks would then be ready to lend again.

To take a concrete example – start with Bank of America's latest 10-Q. Bank of America holds 2.3 trillion in assets. In terms of liabilities, the company holds $1 trillion in deposits, $500 billion in long-term debt, and about $600 billion in other liabilities. Equity is worth about $230 billion.

Let's say Bank of America runs into trouble, and their shareholder equity (stock) plummets to $75 billion as a result of $155 billion in losses. The company enters bankruptcy, and is held in FDIC conservatorship. A judge can begin by writing down equity to match expected asset losses. Next, she can wipe down, say, half of that long-term debt and turn it into equity in the new company. If that's not enough, the court can go after the other liabilities. Subordinated debt will be wiped out first, then senior unsecured debt. That's it. Bank of America opens the next day having written down large portions of their toxic loans, and is recapitalized by their long-term lenders. The FDIC can now sell this entity off in an auction, or the bank can be reincorporated to make new loans. Deposit accounts are entirely unaffected.

This proposal manages to do everything we want bankruptcy to do, while tailoring the response for financial institutions. In bankruptcy, we recognize that firms have failed and kick out old management. Lenders take haircuts in order of seniority, but do better in bankruptcy than in liquidation. Meanwhile, these firms – now recapitalized, and without toxic assets – are free to raise further capital and lend.

These proposals recall the bank holiday measure adopted by FDR. After a run on banks, FDR shut down the banking system, and only re-opened solvent banks, which were now backed by a FDIC guarantee. The public had faith in the revamped system, and redeposited roughly half of the money that they previously withdrew.

If banks can fail and start again, they will not feel the pain of legacy debts as they restart lending. If we can create an orderly process for a firm to fail (without systemic repercussions), banks can’t then count on escaping a wind-down and will be less inclined to place new risky bets (while counting on a future bailout).

At minimum, the “bail in” idea should be studied further. The recent financial reform bill mandates a study on contingent capital requirements for nonbank financial companies, and authorizes the Board of Governors of the Financial Reserve to mandate contingent capital reserves. Additionally, resolution authority grants regulators the ability to wind down financial institutions in a bankruptcy-like manner. Armed with these powers, regulators have only themselves to blame if a future crisis saddles taxpayers, rather than financial participants, with losses.