Sunday, 31 May 2009

Arbitrary conviscation is a good thing

OK, maybe that is a little provocative. But here's the reasoning. Any effective special resolution regime for banks has to intervene early. That means sometimes seizing banks (particularly too big to fail banks) which are well capitalised and liquid because the supervisor thinks that it is better for the system to act now than to wait. They need to have the power to do that.

How would such a regime work? Broadly the regulator would monitor signs of stress: capital ratios, ease and cost of funding, stress tests, loan performance and so on. The range of indicators should be broad, and over time more can be developed. If one or more of these gauges suggest a looming problem, or just because the regulator thinks it wise, the bank would be seized. Either it would be sold to a stronger, well capitalised peer or a good bank/bad bank split would be made, with shareholders ending up with a stake in the bad bank. (I prefer the latter as the former tends make big banks bigger, something I think is a bad thing.)

The result of this kind of power is events like the takeover of WaMu. Some people claim that this was unfair and unwarranted. (See here for John Hempton's take on the FDIC's action here. I don't know enough of the details to know if John's account is fair, but he certainly makes some interesting points.) But even if a seizure is arbitrary, I still think that the supervisor needs to have the power to do this kind of thing, and that that power should be exercised if there is a reasonable suspicion - no more - that the bank is in trouble.

Why? Well because if banks thought that this really was likely, they would take more care to stay safe. Conviscation is an effective moral hazard prevention mechanism. Providing that shareholders know that their rights can be voided by the regulator more or less whenever they like, they will demand that banks are run in a demonstrably prudent fashion. What's not to like about arbitrary conviscation?



Blogger Phobos said...

Powerabuse but with strict rules this idea sounds quite good.

8:19 pm  
Blogger Dave said...

I get the idea, but I'm not sure that it needs to be "arbitrary" or "confiscation".

If the indicators - and the thresholds for intervention - are publicly known and the regulator is required to intervene whenever a threshold is breached, this is not arbitrary (except to the extent that the thresholds are arbitrary - but that is true of all regulation).

If the regulator then forces a good-bank bad-bank split, this does not confiscate any assets, it simply reorganises them.

I agree that the buyout alternative is unhelpful, as it can make a too-big-too-fail bank part of an even bigger bank. Furthermore, a forced buyout does represent a confiscation.

One thing that mystifies me. Why don't banks voluntarily restructure themselves into good-bank bad-bank? This would seem likely to benefit shareholders. Would there be problems with the bondholders?

11:56 pm  
Blogger David Murphy said...

Dave -- Partly the title was a provocation, but partly I used 'arbitrary conviscation' to emphasise that regulatory action is something that can (and should) deprive existing shareholders of their rights, and they should get used to it. In some quarters at least the mantra of shareholder rights runs deep - look at the hedge funds sueing the UK treasury over Northern Rock - and it is worth pointing out how damaging this model can be to financial stability.

One thing that mystifies me. Why don't banks voluntarily restructure themselves into good-bank bad-bank? This would seem likely to benefit shareholders. Would there be problems with the bondholders?One of the points of bad bank/good bank is that you remove the banking license from the bad bank so that it cannot take deposits or make more loans, and debt holders end up with a claim at least partially on bad bank. Given that the option to carry on doing business is very valuable (especially in a yield curve environment like the current one where the pickup from lending long and borrowing short is big), bond holders are not very keen on the idea. Most bond covenants would in fact not permit it - so the split can only happen if the regulator steps in and enforces it.

Finally, I'm not sure that it is good for shareholders. Lehman in 98 is a good example - after LTCM, they were in almost as much trouble as in 2008. But they insisted they were OK, rebuffed regulatory scrutiny (this was the SEC remember, not the FDIC), and marked their assets optimistically. That worked: the assets did perform (or at least enough of them did), and they eventually rose back to where they were marked. If Lehman had said 'boy, we're really screwed', and split into bad investment bank/good IB, I suspect that the shareholders would have been wiped out, as Lehman's repo and CP funding would have disappeared. The confidence element is important: it is in shareholders' interest for banks to act as if they are fine even if they are not.

8:31 am  

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