Bad banking

Willem Buiter suggests that Many high-profile, large border-crossing universal banks in the north Atlantic region are dead banks walking - zombie banks kept from formal insolvency only through past, present and anticipated future injections of public money.I think this is over-stated. We simply do not know if they are solvent or not. We do know that without state support many of them cannot raise funding, but that is different from insolvency.

In this context, let us walk through a clean up process. Suppose that the state decides that a bank can no longer continue as is. The bank is seized. Its business and deposits are spun off, either as a depositor-owned cooperative (actually my favourite answer) or if need be as a new good bank. That leaves the old toxic assets. What should happen to them?

The problem is two fold. Many of these assets are illiquid and impossible to value. Moreover they cannot be funded on a stand alone basis. In order to prevent a collapse of financial asset values, the state can, and should, assist in funding these assets at a reasonable rate. So... put the assets and liabilities into a new vehicle, aka a bad bank. Do not comingle assets and liabilities from different banks: have one bad bank per rescue.

Any given bad bank will have mismatched funding, in general. Now comes the problem. What do we do with debt which matures before assets? To make this concrete, suppose that the bad bank contains $100M of 5 year loans, funded with $10M of shareholder's funds, $40M of short term senior notes, and $50M of 5 year bonds*. The loans will not all pay, and the equity is likely worth nothing, but we do not know that yet.

The notes mature in three months. But they cannot be paid in full because the government at that point the central bank would have to step in to provide more funding for the vehicle. I don't see any alternative to maturity extending the note holders out to five years, at which point we will know how much the loans are really worth. At that point we can allocate funds according to seniority, with the state getting paid first, followed by the senior debt holders, followed by the equity holders if there is anything left. But should the extended debt pay interest, and if so, at what rate?

It does worry me slightly that this is inequitable between the note holders and the bond holders. The bond holders expect to get paid in five years, and they will be (albeit not necessarily getting par). The note holders expect to get paid in three months, and they have to wait five years too. Seniority matters, but maturity doesn't in this model.

Moreover, what should we do about off balance sheet commitments in this model? If the loans had been swapped to floating, say, matching floating rate liabilities, then we may need these instruments. Yet at the moment, anyway, all derivatives would terminate on take-over. And what about committed lines of credit?

I only make these points because it is really not clear to me what the clean up regime for banks should look like, and what is genuinely equitable to the holders of all the different types of claim that there may be. Designing a new insolvency regime is a non-trivial matter, especially if you want both to avoid moral hazard and to avoid unjustified appropriation.

Update. *It would be more realistic to say $10M of 5 year bonds and $40M of government loan, since typically we will have sold the deposits which are funding some of the assets on.