Are Banks Too Big to Save?

An excellent comment in the Financial Times by Wolfgang Munchau discusses how the gold standard for handling banking crises, the Swedish model, would take even more discipline to implement in the US and how we are dong the reverse of what is needed.It is a levelheaded analysis which stands in stunning contrast with a bit of advocacy masquerading as economics from Larry Summers in the same section of the FT today.

But in the course of his discussion, Munchau makes the observation that none have dared face up to: the financial system is too big for governments to rescue. We’ve given the weaker form of that argument: the US, or even the US plus all the world’s central banks, cannot keep a massive, multi-market asset bubble from deflating. But not only can the current financial system not be saved, it shouldn’t be saved. The debt binge means it is at an unsupportable, bloated scale. It needs to be trimmed down to a more viable size, and only that level should get government support.

From Munchau:

Last week’s dramatic events hold two transatlantic lessons in opposite directions, one from Europe to the US and one the other way. The first comes from Sweden, which suffered its own financial crisis during the early 1990s. The Swedish lesson is that bank bail-outs should be handled conservatively and should come in the form of direct capital injections.

As in the US, the Swedish financial crisis was also preceded by a property bubble, which was pricked by a rise in real interest rates. Severe stress in the financial system and the economy were to follow. In each of the three years 1991, 1992 and 1993 Swedish gross domestic product fell in real terms, at an accumulated rate of about 5 per cent.

In response, the Swedish government set up an agency to recapitalise the financial sector. Bank shareholders were not compensated. But the Swedish government did not bail out all banks, only a subset. They used a microeconomic model to determine which of the banks had a chance to survive, and which did not. Those that did not were liquidated or merged. And those that were bailed out had to write off their bad debts first. All depositors were covered by an explicit government promise of compensation. The goal was to minimise the cost to the taxpayer, and it succeeded. It turned out as one of history’s most successful financial system bail-outs.

There are naturally important differences between the situation in Sweden then and the US today. The most important is that our most recent bubbles surpassed anything we have ever seen before. We do not only have to deal with a bursting property bubble, but also with the huge leverage effects through the credit markets.

The US has a much bigger problem today than Sweden did then. Like Sweden, the US needs to shrink its financial sector before saving it. The difference is that the US needs to shrink it a lot more, and wants to shrink it a lot less.

In this context, Daniel Gros and Stefano Micossi last week made an astute observation on these pages: several European banks have become so large that their governments could no longer save them. Banks once considered as too big to fail have become too big to save. Unlike the German government, the US administration is in a position to save its largest bank, but is not big enough to save its entire financial system.

The problem with the original Paulson plan is not merely the lack of direct equity injections. By purchasing junk securities at above market prices, the plan is indiscriminate in that the bail-out would apply to each bank with junk debt on its balance sheet. It would recapitalise the financial sector in its current form, an exercise that is simultaneously unfair and futile. The new package, if finally implemented, is not going to resolve that fundamental dilemma either.

Without a contraction in the financial sector, the US administration risks a debt explosion, and a sudden withdrawal of foreign financial investors. This is the other big catastrophe looming large in the background. We are facing two big tail risks from different ends. Failing to rescue the banking system could lead to a depression. But so could a rescue if it produced macroeconomic instability.

What about the lesson from the US to Europe? It is that bank bail-outs require a swift political response. When you look at the eurozone, it is not clear at all where this response could come from.

By the time European ministers have travelled for a meeting in Brussels, let alone reached or implemented a decision, the financial markets would have long melted….

While the Americans need a better rescue plan, the Europeans need a lot more: a system that could produce a rescue plan in the first place.

Munchau may be being a bit hard on the EU. It managed, contrary to expectations, to put together a package for Fortis, and Willem Buiter hails the accomplishment.