The Best Policy Regarding Banks
By Arnold Kling
At some point, politicians are going to have to stop pandering to their constituents and show leadership by explaining why the economy can’t survive without a banking system.
Hear we go again. We hear a rising chorus of cheerleaders for “recapitalizing” banks. Instead, let me remind readers of the first suggestion I made, way back in September. That is, the regulators should make use of capital forbearance for solvent banks and close insolvent banks.
Are the banks that are in trouble insolvent or illiquid? If they are illiquid, then capital forbearance would keep them going. Capital forbearance means lowering the capital requirements for the banks to remain in business and to continue low-risk lending.
If the banks are insolvent, then throwing more capital at them is the infamous zombie bank strategy. Propping up zombie banks encourages them to continue to lose money, make risky bets, and make it harder for healthy banks to compete.
The regulators may whine that the “toxic assets” are hard to value, making solvency difficult to determine. However, I think that triage is possible. Based on the best estimates of the value of “toxic assets,” classify banks as either healthy, insolvent, or somewhere in between. If they are insolvent, close them. If they are somewhere in between, give them capital forbearance, but put them on a tight regulatory leash otherwise. Limit their ongoing asset acquisition to low-risk lending. When the dust settles, presumably some of these banks will turn out to be healthy. The rest will cost the taxpayers some money, but presumably the tight regulatory leash will keep the banks from adding to their (our) losses.
It may be a bad idea to try to survive without a banking system. Trying to survive with a banking system that consists of insolvent banks artificially propped up by the taxpayers is an even worse idea.