To come out of it, use all the exits and get the incentives right

Salvatore Rossi

25 February 2009



Let’s recapitulate some basic facts and analyses. A recession/depression spiral is gathering strength all over the world. To stop it, we need first to get credit to flow again. This is an absolute precondition. No fiscal package, however big and well conceived, can work unless the heart attack that has stricken the global financial system is cured first. On this, there is a vast consensus of opinion.

Consensus on the problem

Credit is rarefied because several banks have a structural balance sheet imbalance. In the last five to ten years, banks across the globe, to varying degrees, borrowed too much relative to their capital and used too much of these borrowed resources to buy assets that proved to be toxic. Now such banks must deleverage. But the uncertainty surrounding the “true” value of their assets is keeping private investors from holding those banks’ shares, lending them money, or purchasing their assets. So the only way they can deleverage is to cut lending to the economy. This worsens the recession, which in turn increases the “bad” portion of banks’ assets, in a downward spiral.

Clearly, this is a market failure, and the public sector must step in. How? Here opinions have not yet converged.

Divergence on the solutions: Two schools of thought

There are two basic schools of thought.

  • One says that government should intervene on the banks’ asset side by buying distressed assets.
  • The other counters that government should rather intervene on the liability side, recapitalising the banks.

The former poses one tremendous problem – how to price assets for which a market no longer exists. The latter poses a problem of governance (moral hazard) that is no less serious.

In the US last year, TARP I was to take the first route, setting toxic asset prices through reverse auctions. This soon proved technically unfeasible, so the program was re-oriented towards the other aim, i.e. recapitalising banks (TARP II). To some extent ($240 billion) that was done, through preferred shares so the control/management of the banks was not called into question. This occasionally sparked public outrage, as people saw a lot of taxpayers’ money flowing into the pockets of banks’ shareholders and managers without any apparent success in unblocking the credit market or halting the recession.

Caballero’s Knightian uncertainty and solution: Universal public insurance

Ricardo Caballero has argued on this site that the uncertainty ravaging credit and financial markets is Knightian, i.e. not amenable to probabilistic assessment. In these circumstances, each individual reacts to the worst-case scenario, which is in general different for the two sides of any transaction, thus leading to an extremely risk-averse behaviour and to a very inefficient double (or multiple) counting and hoarding of resources (liquidity). Hence the main (though not exclusive) role of government should be to provide explicit and systemic insurance, at non-Knightian (pre-crisis) prices.

In this analysis, while the amount of capital required to restore normal conditions would be very large, to offset the inefficient hoarding of resources, the impact of the provision of insurance, by removing for each agent the worst-case scenario, would be multiplied several times over. Essentially, Caballero calls for a variation of the asset-side approach – a universal public insurance for distressed bank assets, at (or slightly below) pre-crisis values, offered to every market participant.

Sachs’ idea on toxic asset pricing

Jeffrey Sachs has suggested solving the dilemma of pricing toxic assets by building a bridge linking the two basic approaches. He wants the public sector to buy distressed assets at face value (swapping them for government bonds for long enough for the storm to blow over), thus effectively cleaning up banks’ balance sheets.

What about moral hazard? Sachs’s idea is that the government should receive warrants on each bank’s capital, contingent on the eventual sale price of the swapped assets. Once the economy is back on track and the assets are liquid again (say, a year from now), if the assets’ value is at least equal to today’s capital, the latter will absorb the possible loss and taxpayers will be safe. If not, taxpayers will sustain the residual loss and the bank will be then nationalised (for resale to private investors as soon as market conditions permit). Since the asset liquidation process is necessarily gradual, in the interim the government should have a sort of receivership, in order to make sure managers cannot strip off good assets.

Geithner’s Plan

Timothy Geithner’s Financial Stability Plan for the US combines the two approaches. In part, it returns to the original TARP intention of cleaning up the asset side of balance sheets, but in a new way. The government will ask willing private investors (private equity or hedge funds?) to find a price for the distressed assets of a bank and to go halves with the public sector in buying them (the details have not been fully disclosed). The Plan also provides finance to private investors willing to purchase new securitised bank loans to small businesses and consumers. On top of that, a capital provisioning scheme is envisaged, whereby government can buy convertible preferred shares (“contingent equity”) issued by capital-short banks, with some conditionality concerning such matters as dividends and acquisitions. The precondition is that these banks must have undergone a comprehensive “stress test” to ascertain all potential losses, due both to toxic “legacy” assets and to the economic downswing.

Other countries have adopted or are considering measures classed in the two categories set forth above:

  1. buying distressed assets (through a “special vehicle,” a “bad bank” or whatever) or providing insurance on them;
  2. recapitalising banks.

I’d like to make two general points.

Two general points

  • First of all, it seems to me that in the countries most affected by the phenomenon of distressed assets in banks’ balance sheets, the two approaches are both necessary at the present juncture, although of course the right mix between them will vary with national specificities.

The main merit of Mr. Geithner’s Plan is precisely that it pursues both. Relying only on the first would mean dangerous underestimation of insolvency risks (see Martin Wolf’s severe critique on “why Obamas’s new TARP will fail to rescue the banks”). Relying only on recapitalisation is subject to Caballero’s objection based on the peculiar state of uncertainty characterising the present crisis, which has blurred the boundary between illiquidity and insolvency. In countries where the “legacy” of past sins in banks’ assets is heavy, it may be preferable to complement recapitalisation with some form of asset cleaning, better if in the form suggested by Jeffrey Sachs.

But the devil is always in the (missing) details, and this is my second point.

  • What determines the success or failure of any measure is the following question: “Are the incentives of all players right or wrong?”

In this connection, more than shareholders, the people to watch carefully are the managers of the banks.

It remains a general principle that a private agent is more suitable than a state bureaucrat for managing an enterprise efficiently. After the miserable show recently put on by so many bankers in some countries, some people there will find this hard to believe. But we must not mistake conflicts of interest and agency problems for lack of professional expertise.

Getting the bankers to help

Let’s make two assumptions. First, that government agrees on this general principle (which is certainly the case in America and Britain, perhaps less in continental Europe) and wants to use the technical expertise of today’s bank managers as much and as long as possible, though putting limits to their “greed”. There is clearly a problem of incentive compatibility here. Why? Because managers – and that’s the second assumption – are better informed than anyone else (shareholders and government in particular) on the true value of their assets (i.e. their likely post-crisis value). It may well be that at the onset of the crisis many bank managers had lost control over the content and valuation of most structured assets, but it’s reasonable to assume that by now they are well aware of what is in their portfolios and able to attach a shadow price to each illiquid asset.
Under these assumptions government’s support may be hindered by adverse managers’ incentives. Here are a few examples.

The government’s interest is to induce banks’ managers to reveal the exact amount of distressed assets in the balance sheet of their bank. But:

  1. If the government offers to buy all their distressed assets at pre-specified prices, the managers’ incentive is to sell only those assets whose estimated post-crisis value is less than the offered price – to extract a subsidy from the public intervention and to minimise their immediate personal reputation loss (which is the more serious the greater the amount revealed of toxic assets). As to the fate of the bank over the longer term, they are just buying time, hoping that in the end the overall public intervention will remedy the general situation and get them out of trouble altogether. From the public interest standpoint, the risk is wasting money and not getting the result.
  2. Similar considerations apply to the case of an insurance scheme à la Caballero (as he acknowledges), even though in this case deductible-like schemes could be devised to reduce the adverse selection problem. If government offers to recapitalise a bank, its managers have an interest in maximising the public capital injection, provided that their freedom of manoeuvre is not too strictly limited. This would go against the interest of private shareholders, who don’t want to dilute their shares, but in the present circumstances their voices are obviously very feeble. The risk for the public purse is putting too much money into banks that may be less in need than others.
  3. If the government buys distressed assets and, at the same time, receives contingent warrants on the bank’s capital, as in Sachs’s idea, managers may want to minimise the probability of subsequent nationalisation, fearing being fired in that event, so they may not sell the whole package of troubled assets, thus jeopardising the recovery of the bank, again hoping that the systemic intervention will work and save them anyhow.

As these examples show, whatever the measure envisaged, its design is essential and must take into account, in particular, the incentives of banks’ managers, in order to make them compatible with the government’s objectives.

Disclaimer: The opinions here expressed are only the author’s and do not involve, in particular, the Bank of Italy.



Topics:  Global crisis

Tags:  financial crisis, toxic assets, Knightian uncertainty

Member of the Governing Board of the Bank of Italy