A Structural Approach to Economic Recovery
Posted Wednesday, November 12, 2:12PMPlease see this new paper:
New American Bank Initiative: Removing structural flaws in the economic rescue
by David Leinweber and Salman Khan
Here's the abstract:
In this paper, we argue for a New American Bank Initiative: use the $700 billion in government funds to capitalize new banks and distribute the shares of the new entities to the American People . These new banks would then acquire the operational and human capital assets of failed banks in FDIC receivership.
New structural flaws in the government’s rescue plans are revealed on an almost daily basis. The incentives for these plans to work to the benefit of the country, and not the failed firms are poorly aligned. The NABI would involve no moral hazard, no hoarding banks, no government ownership, and no throwing good money after bad. Most importantly, it will immediately provide $7 trillion or more in unencumbered lending capacity to real projects—green energy, infrastructure, auto and other manufacturing, . It is also the best plan for preserving the operational and human assets of failed banks and saving existing solvent institutions by making everyone confident in the availability of funds again.
This effort started out as a short segment on CNN on October 10th, 2008 , but has since been expanded and circulated for criticism and comment. This paper is a much more in-depth discussion and elaboration of the plan, based on the questions raised in that process.
Link to html version: http://cift.haas.berkeley.edu/docs/nabi/nabi.html
Link to pdf: http://cift.haas.berkeley.edu/docs/nabi/nabi-Nov11.pdf
Since one side effect of this plan would be New Banks lending to Old Banks, John had asked about how different this plan is relative to the the Treasury essentially picking which banks to inject capital into. This was my response:
Right now, a lot of the lending is not happening (both within the financial world and to the real economy) not because of fears of insolvency, but because of the fear that the borrower won't have the ability to roll-over the loan to another party once it comes due. This explains why access to funding has become very "digital"; you either get it at a low rate or you don't get it at all.
Let's say you need a $1m loan to operate a low-risk business with $200k/year pre-interest-cash-flow/EBITDA. You can clearly cover the 10% interest but I don't want to commit to you indefinitely. In a normal environment, I would loan the $1m for a 1 year term and if I didn't feel like extending/renewing it, you would find another 1m loan from someone else to pay me back a year from now. However, if I think that you might not be able to replace the loan in a year, my one-year commitment is essentially much longer (no one benefits if I take you into bankruptcy for defaulting). I have to worry about my own liquidity first, so I decide not to lend. This ends up being a self-fulfilling prophesy.
On the other hand, New Banks would not be anywhere near as concerned about their liquidity so they would be willing to take the risk that you won't be able to find another loan at the end of the year. They would put covenants on the loan that allow them to get a higher interest rate if that happens, so as long as your ability to cover the interest doesn't deteriorate, the new bank will actually get an even better return.
By taking this first step, the entire banking system will regain their confidence in the notion of access to funding a week, month, or year from now and would feel more comfortable in the liquidity of term loans. This and the notion that the New Banks are making a killing on "low hanging fruit" would spur the more solvent existing banks into action.
If no one makes that $1m loan to you, your business will suffer and you (and your suppliers) are more likely to default on your/their other debt (further impairing the quality of assets already on "Old Bank" balance sheets.
I view New Bank lending to Old Bank as a special case of the lending-to-a-business-that-is-good-for the interest-but-may-not-be-able-to-roll-over-the-loan problem, but it is not the essential argument. The essential argument is that the New Banks keep good real businesses from starving for capital and the Old Banks benefit as a side effect.