There have been numerous recent proposals put forward that bad banks should be allowed to go bankrupt by the government and a new banking system which is under temporary state control should be set up in order to prevent the country from being crippled due to the propping up of a corrupt financial system. Under the terms of this proposal, toxic assets would not be removed from a bank's balance sheet but would instead be set aside in a “side pocket”, and additional capital would be put in to help recapitalise the bank. (The term Toxic Assets refers to any assets with a fair value which cannot be determined accurately. Conversely, Clean Assets are those with an easily determined fair value). Other proposals, however, have a very different view of how to deal with bad banks. Another proposal, for example, has suggested that a new good bank could take on any insured or guaranteed deposits from the legacy bad bank, which would, in turn, lose its banking licence, and buy up all of the legacy bank's good assets. Although initially the state would need to make up any difference should good assets be less than deposits, with government debt, a new good bank would then be allowed to borrow from the sovereign in order to finance their acquisition of the bad bank's good assets, cleansing the bank's balance sheets.
The Toxic Assets Problem
When toxic assets overhang on a bank, they act like a tax on any new lending. Through regulation or due to market pressure, a bank is required to hoard liquidity and capital instead of lending more money to the real economy. Financial support in all its various forms which leads to the creation of bad banks that are publicly owned has turned out to be a failed enterprise in numerous cases. In order to pay the owners of toxic assets enough money to induce them to sell, the sums required would be incredibly high and this may leave insufficient fiscal resources to support essential new lending activities, and nationalising these bad banks cannot resolve the problem either, as the amount required to pay for them can only depend on their toxic asset's evaluation.
The Unfairness of the Bail Out
It is very unfair to bail out bank creditors and holders of any existing banking debt, as they should be made to stand to account for their own investments and losses. Not only that, but in the case of a banking bail out, many creditors end up actually better off than the public expenditure beneficiaries and tax payers that are financing it. Not to mention the incentives being created for risk taking in the future by banking organisations. Policymakers, central bankers and regulators should pursue 3 main objectives: Firstly, to get banks to lend to the real economy once more. Secondly, to minimise moral hazards through the creation of appropriate incentives for risk taking in the future by banks and creditors, and by ensuring that any losses that have been incurred by a failed banking system are borne by those who invested in those banks. Thirdly, to seek justice when sharing the burden. After selling on their good and valuable assets and shedding guaranteed and insured deposits, bad banks should then have just one remaining activity – the management of existing assets. They would undertake no new investments, make no new loans, and incur no new exposures, with their funding decisions and liabilities then being managed solely in the interest of their existing shareholders.
Focusing of Fiscal Resources on New Lending
If fiscal resources are focused on supporting the flow of new lending, or new funding to support the new lending, instead of supporting the stock of existing toxic assets, the state can easily meet its 3 main objectives: namely, stabilising the economy in the short term, minimising incentives for risky future lending, and making the system accountable for its investment mistakes. Establishing clarity between new good banks and legacy bad banks is essential to fulfil the economic imperative to support the flow of new borrowing and lending instead of protecting the existing stock of bank's toxic assets.
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