What next

What next

If the panic of the next week of October 2008 worsens, governments have to be ready to stop it using auditing, recapitalisation, and liquidation. A stopgap stabilisation plan is always to guarantee all banks’ short-term liabilities, audit their assets, and tidy up the mess.

We are in a midst of a banking panic due to concern over the grade of bank assets and the adequacy of bank capital. Interbank lending has stopped and lending to non-banks is grinding to a halt. We are in need of intermediaries to begin with functioning again in order to avoid a deep recession.

The historical recipe for stopping a panic can be an automatic stay (or suspension of convertibility) that freezes the power of creditors to withdraw their money. This buys time in order that authorities can audit the banks, decide who’s solvent, wind down or recapitalise the shakiest banks, and prevent the panic. Today, however, short of failing a bank, such a stick to short-term debt or deposits is impossible.

Possibly the various guarantees made during the last few days will end the panic. But we should prepare for the choice. If the panic continues, it could be stopped with the original tools of auditing, certification, recapitalisation, or asset liquidation. The task is usually to be ready with an idea to do this within regulations and without increased incentives for short-term creditors to perform.

Our plan is for regulators to get time by guaranteeing all banks’ short-term liabilities for a limited period. This would total saying that securities maturing within the next three months will be federally guaranteed and may be rolled over up to five months. To avoid gaming, asset growth would have to be limited by normal lending growth. Dividend payments will be stopped.

The timeout will be used to verify asset quality and establish capital adequacy. This might focus on rapid audits of bank assets, marking to advertise using common pricing assumptions across banks (above fire-sale values), with the purpose of establishing the relative net worth of the banks. Banks will be invited to improve additional capital, with the knowing that any capital raised will be senior to existing capital (except perhaps recently raised capital). If the banks subsequently would have to be liquidated or required government capital infusion, these new investors need the assurance they’ll be protected (their seniority respected) – otherwise they’ll not participate. The banks that emerge with higher capital might use the funds to get weaker banks. The weakest banks, which no-one wants to buy, will be wound down. If as it happens a number of banks are insolvent, despite the fact that their core capabilities such as for example local knowledge have value, they may be failed and recapitalised by the federal government (without imposing any losses on the short-term creditors).

This plan ought to be seen as a stopgap measure. It’s possible that the asset purchases beneath the Troubled Asset Relief Program will eventually help, both to permit banks to market without depressing prices also to permit the market and regulators to value banks. Likewise, schemes targeted at stabilising home prices, if done on an enormous scale, could influence the worthiness of bank assets. But these kinds of solutions are infeasible for a while and helpful only when investors believe that they’ll stop the lender run and make banks solvent. With the amount of at-risk institutions growing each day, stabilising the bank operating system should be the first priority.

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