Driven by greed combined with sheer incompetence, the executives of a good number of American banks and their boards of directors have morphed their previously healthy banks into zombies in the past half-decade. They borrowed $30 to $40 for every dollar of their shareholders’ equity, driving down the banks’ capital ratios (the ratio of shareholders’ equity to total assets owned by the bank) below 5 percent. With that huge debt, the banks bought high-yield but high-risk assets whose market values have plummeted sharply since 2007. Consequently, many banks now are technically insolvent zombies. By some estimates, the market value of the banking sector’s assets could be $2 trillion to $3 trillion short of the amount of its total debt.
In an economy saddled with a large number of zombie banks, many innocent bystanders are likely to get as sick as the zombie banks themselves because the latter cannot properly fulfill the mission of channeling funds efficiently from savers to creditworthy borrowers. To help the rest of the economy, then, the zombie banks must be rendered harmless one way or the other, and the sooner the better. The question is how that should best be done.
One approach would be to let economic nature run its course by letting these banks slide into bankruptcy, under which the existing shareholders typically are wiped out and unsecured creditors become shareholders. Because normal bankruptcy can be a lengthy legal process, however, the preferred route would be a so-called “prepackaged bankruptcy” under which all of the legal and financial terms of the bankruptcy are prespecified by the government and the restructuring would occur swiftly. Its aim would be to increase sharply the banks’ capital ratios so that they would once again feel comfortable making loans to creditworthy customers. (See, for example, University of Chicago economist Luis Zingales' "Plan B.")
An alternative approach, proposed by a number of economists in the U.S. and the U.K., would be to split the zombie banks in two, creating new commercial banks with much higher capital ratios. The remaining old banks, with varied divisions and assets, would be left to fend for themselves without government assistance. The new banks would be structured to be financially strong, procure funds from government-insured depositors and make loans to Main Street like any traditional commercial bank.
There are several ways this second approach could be accomplished.
The government simply could force the zombie banks into such a split, ideally without injecting taxpayers’ money into the operation. Under that approach, the old banks’ least risky assets and their government-guaranteed deposit liabilities would be transferred to new commercial banks, which might be endowed with a capital ratio of, say, 20 to 30 percent. In the absence of capital infusions from taxpayers, the shareholders of the old banks would own the common stock of the new commercial banks plus the common stock of their old banks. The hallmark of this plan is that neither the old nor the new banks would be nationalized.
Instead of merely forcing a split of the zombie banks, however, the government could become the new banks’ major or sole shareholder by endowing them with public funds in return for newly issued common stock. The new banks would then remain nationalized — owned by the taxpayer — until they were resold to private investors several years later, as was done in Sweden in the early 1990s. The new banks, also endowed with comfortably high capital ratios, would operate as financially strong commercial banks that take deposits and make loans. They could buy low-risk assets from the old banks, but otherwise leave the latter to fend for themselves without government support.
President Obama, his Secretary of the Treasury Timothy Geithner and the new Congress have chosen as a third route largely the same one traveled by their predecessors. For reasons not entirely clear to me, they seek above all to protect the position of the zombie bank’s creditors, their incumbent managements and boards of directors and, to the extent possible, their existing shareholders — all at taxpayers’ expense.
Evidently the President, his Treasury Secretary and the Congress have more faith in the managerial acumen of the executives and the boards of directors who drove their previously healthy banks into zombie status than in any new managers and boards government might appoint. Evidently they are also not bothered by the moral hazard they create with bailing out folks who should fully bear the risk of managerial incompetence. And just as evidently, neither Main Street nor Wall Street seem much impressed by that strange approach.
Uwe E. Reinhardt is the James Madison Professor of Political Economy and a professor in the Wilson School. He can be reached at reinhard@princeton.edu.
Read More
Why can’t lecturers win the President’s Award for Distinguished Teaching?
Jerry ZhuLet’s acknowledge those who make “boutique teaching” possible, those who work tirelessly to make our rigorous curricula more accessible, and those who dedicate their time to advising and guiding us through all the challenges we face at this University. Lecturers should be eligible for the President’s Award for Distinguished Teaching.
Let’s acknowledge those who make “boutique teaching” possible, those who work tirelessly to make our rigorous curricula more accessible, and those who dedicate their time to advising and guiding us through all the challenges we face at this University. Lecturers should be eligible for the President’s Award for Distinguished Teaching.
Princeton’s administration of justice is Trumpian
Frances BroganThe disparity between the University’s approach to Giberson and its approach to pro-Palestinian protestors reflects a concerning trend of appeasing an increasingly emboldened right rather than resisting the threat it poses to academic freedom and the wellbeing of Princeton students.
Secular Opening Exercises? Don’t throw out the baby with the bath water
Frank StrasburgerThe secular makes no room for the spiritual. What Opening Exercises are meant to convey is the spirit of the institution so that it may be kept alive from generation to generation.
The secular makes no room for the spiritual. What Opening Exercises are meant to convey is the spirit of the institution so that it may be kept alive from generation to generation.
