Resolution of Systemic Financial Problems – How Should Spain do it?

Systemic financial crises require swift and comprehensive solutions by the government.  In 2008 it quickly became clear that characterizing the U.S. securitization crisis as one of liquidity was inaccurate, and hoping that it would be cured by auctioning off increasingly poorly collateralized central bank loans to distressed firms was futile.  That led to -TARP- a plan to repurchase troubled assets from banks, which quickly evolved into a bank recapitalization plan when it became clear pricing toxic assets was nearly impossible. 

More recently, Spanish banking system has seen its situation worsen, partly because of Madrid’s failure to force an earlier cleanup of bad debts stemming from a real estate bust.  Austerity measures to remedy the region’s debt crisis have since led to greater deterioration of Spanish bank balance sheets, as more and more Spanish businesses folded and homeowners went into foreclosure.  Over the weekend Spain became the largest euro-zone nation to seek an international bailout, and the 17-nation currency area agreed to lend Madrid up to $125 billion for its bank rescue fund.  At this point there is little disagreement that there needs to be a broad-based approach to resolve the Spanish bank insolvency problem, but not as much discussion over the form it should take.

What principles should guide public policy in this context? Clearly, governments should be prepared to act in a systemic crisis. However, the approach and the actions taken still need to be designed to reduce conditions for moral hazard and the likelihood of a subsequent crisis.  This should be done by imposing real costs on all responsible parties and getting the resources back in productive use as soon as possible. 

To see the importance of attention to incentives, consider what happens to firms outside the financial sector that fall into a state of insolvency.  Those in control of the firm find it difficult or impossible to raise new funds in any form. They can no longer act on profitable investment opportunities and may be forced to sell important assets.  Creditors recognize this situation may distort the incentives of managers, making them more susceptible to fraud and moral hazard, and at the very least reduces the incentives of the owner and managers to exert effort.  In a market economy, the solution is bankruptcy.  As long as the firm is economically viable, it makes sense to continue its operations, but only after restructuring.  This restructuring generally wipes out existing equity holders, while debt holders often have a portion of their claims converted to equity.  Alternatively, debt holders can agree to cut down the face value of their debt, in exchange for some warrants.  Old management is often replaced, a substantial portion of the firms’ assets are sold, workers are laid off.  This restructuring is not a mere reworking of the firms’ balance sheet, but represents very real changes to the way it does business, perhaps even in the business it does.  The happy result for the economy is that resources continue in their best use while all responsible parties incur some costs for the firms’ poor performance.

To a large extent dealing with financial insolvencies should follow the same general principles.  Admittedly financial sector is special due to its particular fragility, possibility of contagion and major macro implications when it is in systemic distress.  However, although these differences may justify different approaches, they do not suggest that incentives matter any less.  Any government involvement should be designed to protect the interests of the taxpayers, impose losses on the responsible parties, and use the private sector to pick the winners and losers.  For example, any plan that purchases bad assets from troubled financial institutions or any recapitalization without extracting some claim from the institutions, amounts to a transfer from taxpayers to shareholders, which is the group that keeps the residual value of the entity. 

Ideally, the intervention should maintain (or restore) a functioning financial system; keep the lid on the budgetary costs of the crisis; and importantly ensure that the design of insolvency resolution scheme helps decrease the likelihood of a subsequent crisis. 

Hence, while a recapitalization of Spanish banks is clearly necessary, those banks that need assistance with recapitalization should be helped in an incentive-compatible way.  Such a plan would limit taxpayers’ loss exposure, and leave resolution of bad assets to the banks themselves.

But how should the banks be recapitalized? Economics and experience suggest some answers¹:

1. Those institutions that are in a strong position should be able to raise capital privately, say from a syndicate of private banks.  If the institution has difficulty raising capital, it should at least be able obtain some proportion of it– at least half of it or more- from the private sector before applying for government recapitalization assistance.  Only those institutions that can secure private sector funds would be eligible for the plan. This will ensure that the private sector plays an important role in picking the survivors.
2. Those institutions that are eligible, receive government assistance in the form of preferred stock.  Preferred stock status would force private parties rather than taxpayers to bear the first-tier losses.
3. Any bank participating in the plan will have to suspend all dividend payments (and restrict the amount and structure of its compensation plans for its senior managers) until the government is fully “bought out.”  The bank will also agree to complying with strict regulations on its leverage and risk-taking, transparency and disclosure to participate in the plan. This will give incentives to banks to retire their preferred stock as soon as possible.

These are tough criteria and only desperate banks will agree to these terms.  Which is exactly the point: government assistance should only be injected into banks in dire straits, yet simultaneously to those with a real chance of survival.  As long as the amount of funding is such that some banks fail, this approach removes government from decisions as to which banks survive.  The availability of private sector funding serves to identify the candidates, and restrictions on different ways to take these funds out of the banks, combined with greater transparency makes it more likely that the banks will not be looted or engage in gambling with tax-payers money.  By openly stating the terms on which it will assist banks, and ensuring that those terms provide good incentives for the restructured bank going forward, the government will have made best use of market forces while minimizing its direct ownership involvement. 

The recognition that Spanish banks needed assistance to recapitalize is an important first step, which was overdue.  But the form this recapitalization should take is equally important.  The burden of recapitalizing insolvent banks should not just fall on the Spanish taxpayers.

^{1 For a fuller discussion of these points see World Bank Policy Research Report (2001) Finance for Growth, pp. 144-154.}