Ambrose Evans-Pritchard published a column this morning suggesting that the U.S may adopt the so called "Nordic model" of nationalizing insolvent banks. The piece has drawn a lot of blogospheric comment. [ Scurvon, Naked Capitalism, Financial Armageddon, Curious Capitalist, Across the Curve ].
You would think that moral hazard fetishists like me would applaud. The "Nordic model" is a very tough approach. When regulators deem a bank insolvent, they nationalize it outright, wipe out the equity holders, and unceremoniously can the incumbent management. That is harsh, as it should be. Managers who steward significant enterprises to ruin should not be rewarded, and stockholders, who earn high returns as compensation for risk, should be held accountable when they err by placing their money in the hands of gamblers.
But what you are hearing from me is the sound of one hand clapping. (Finally, an answer to that riddle!) An automatic policy that wipes out equity but makes all creditors whole creates a perverse incentive. It suggests that anyone investing in a bank should structure their investment as debt to capture the implicit guarantee. But highly leveraged balance sheets are a source of the brittleness that leads to banking crises in the first place! Our policy preference should be for equity rather than debt financing, as less leveraged firms respond much more flexibly to adverse shocks. Regulation can address this to a certain degree, but unless bank finances are kept very, very simple, probably not so much. Clever minds can come up with all kinds of contingent liability arrangements that would evade regulated balance-sheet ratios while serving as debt financing, even if "special purpose entities" are banned.
Since debt can substitute for equity, killing common stockholders while making whole even junior creditors amounts to a loophole by which lazy investors can shirk their duty of market discipline. It's not easy to learn which firms are genuinely worthy of ones trust, but that work is precisely what investors get paid for when they earn better-than-risk-free returns. Bondholders, counterparties in derivatives transactions, and other creditors are supposed to assess the credit risk of the firms with whom they entrust money, just as stockholders evaluate business risks. Letting bank creditors enjoy high-returns effectively risk-free creates an obvious arbitrage: short Treasuries and lend as much as you can to any firm that is too big to fail!
There is one and only one class of creditors to whom we have, as a matter of public policy, agreed to make whole under all circumstances. Those are small depositors, and they should bear no risk or inconvenience whatsoever should a bank run aground. All other creditors knowingly assume credit risk when lending to banks, and should be forced to bear some downside when a bank goes south. Admittedly, reducing this theory to practice is walking a knife's edge. The goal of nationalizations and bail-outs is to keep the financial system functioning smoothly. Too harsh a policy towards creditors might provoke self-defeating runs at the first whiff of trouble.
Can this circle can be squared? Probably. Creditors who try to accelerate replayment in advance of a firm's insolvency can have the funds clawed back under the doctrine of preferential payments. Regulators can make clear that recently withdrawn funds will be pursued aggressively, in order to treat all creditors equitably. It makes less sense to stage a run on the bank if you know that the bank will come right back and stage a run on you. Creditors will hate all this. They will fume. Creditors are supposed to hate insolvencies. That's the point. They should have thought about the risks ahead of time, and better supervised the firms they were lending to.
That said, creditors obviously oughtn't be wiped out entirely like shareholders. The point here is to remind the market that on the liability side of a balance sheet lies a continuum of risk, not a bright line between junk and safety. The financial world does require a superhero, but not the Fed-on-steroids of the Paulson proposal. We want the bond vigilantes back. It's probably sufficient to wipe out the equityholders (both common and preferred, there's no basis to discriminate if the bank is genuinely insolvent) and let creditors suffer some delay and uncertainty prior to repayment, perhaps with a small haircut inversely proportional to seniority of claims if public funds need to be deployed.
Writing this stuff makes me feel mean, nasty, cruel, low. Isn't it enough to take a pound of flesh from stockholders? Must we go after the creditors too? But remember, the creditors are mostly getting bailed out here, by you and me, the taxpayers. A bit of inconvenience and frayed nerves in the service of an important policy goal is not so much to ask in exchange. And there are few public policy goals more important in the financial world than getting more equity and less debt on corporate balance sheets, and encouraging all classes of investors to exercise a lot more adult supervision over the firms that they fund.
- 4-Apr-2008, 1:20 a.m. EDT: Added update re the Dean Baker post.
|Steve Randy Waldman — Tuesday April 1, 2008 at 12:45am||permalink|