Tag: FDIC

Resolution of First Republic Bank

JPMorgan Chase’s purchase of First Republic Bank appears to be a standard purchase and assumption resolution of a failing bank. The Federal Deposit Insurance Corporation (FDIC) has organized hundreds of such bank resolutions there by painlessly purging bad banks for the banking system. The only mistake in my view was selling it to the country’s largest bank.

Purchase and assumption resolutions involve the simultaneous purchase of a failing bank’s good assets and the assumption of its deposit liabilities by a good bank and putting what’s left into bankruptcy (wiping out its shareholders and some or all of its corporate debt). Its the risk of loss to shareholders that provides the market scrutiny of bank risk taking. “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution And Ways to Overcome Them”

Money (currency and demand deposits) should not be at risk of a bank failure. Depositors should not need to evaluate the safety and soundness of the bank they chose to hold their money in. So the FDIC insures deposits up to $250,000. But all deposits in the last three banks to fail were made whole whether insured or not and there is talk that all deposits should be explicitly (rather than just implicitly) insured. Central Bank Digital Currency (CBDCs) would provide such total protection to those holding it (retail CBDCs would be issued/administered by commercial banks and fully backed by an equivalent amount at the central bank).

Public “runs” on banks in order to move vulnerable deposits to cash or a safer bank, result from the fact that banks can fund long term loans with callable deposits. They can lend your deposit to someone buying a house with a 30-year mortgage. This works as long as banks keep enough cash or quickly liquidated assets on hand to cover any deposit withdrawals their depositors might want to make. An alternative to deposit insurance for all deposits is to isolate demand deposits from bank lendable resources by requiring that they be 100% back at the central bank (as with CBDCs) and not available to cover any losses on other bank activities.

It is time to take so called narrow banking (or The Chicago Plan) seriously. CBDCs are the natural vehicle for this restructuring of our money and credit systems.  “Protecting bank deposits”

Looking Back on Occupy Wall Street

The evening of September 16, 2008, I met Randy Kroszner for dinner at Et Voila in the Palisades just outside of Georgetown. He arrived late explaining that the Fed’s monthly monetary policy meeting had lasted longer than expected. Randy is a Governor on the Board of Governors of the Federal Reserve. The attempt to rescue Lehman Brothers over the weekend had failed and it had declared bankruptcy the day before, so we had a lot of interesting things to talk about. Randy didn’t mention that the Fed had just agreed to lend up to $85 billion to AIG to cover its expected loses on its mortgage related Credit Default Swaps, thus giving the U.S. government a 79.9% equity stake in the insurer in the form of warrants called equity participation notes. When news of the AIG bailout was posted on my phone around 9:00pm during our meal, I asked Randy what in the world was going on. He was reluctant to discuss the topic uncertain whether the source of my news was a leak or an official Fed press release.

The housing bubble had started to deflate in 2007 and homeowners and their mortgage financiers were coming to grips with the reality of significant financial losses. “The DEFs of the Financial Markets Crisis” and “The Big Bailout–What Next?” While the Federal Reserve quickly reacted to inject liquidity into the banking system to compensate for the freezing up of the interbank credit market that followed the Lehman Brothers-AIG shockwaves, the key questions were who would bear these losses and how should they be contained to avoid spilling over to the financial system more broadly.

The Fed, with the help of $700 billion authorized by Congress in the Troubled Asset Relieve Program (TARP), bailed out Wall Street and contained the spread of potential bank failures. It was a scary time for all involved. Looking back from the relative calm of today with criticism of policy actions taken then is a bit unfair but how else are we to learn from experience?

The government actions in 2008 can be broadly stated as: a) providing all of the liquidity the financial sector needed following the Lehman Brothers collapse and financial panic; b) bailing out large banks and other financial institutions that might have been insolvent whether they were or not; and c) leaving underwater homeowners to drown. The first of these—providing liquidity—is universally accepted as a proper function of a central bank and one that the Fed executed well. The other two—bailing out banks but not homeowners—are the subjects of this note. I will review them from both an economic and a political perspective.

The economic rational for bailing out Wall Street was that there was a risk, with very uncertain probability, of the failure of large Wall Street institutions spilling over to and bankrupting other financial institutions holding assets in the failed Wall Street firms. Many of them were foreign (especially German Landesbanks) and no one knew for sure where the contagion might end. By saving Wall Street, the argument went, the government was saving Main Street as well (trickle down). Sheila Bair, then the Chairman of the Federal Deposit Insurance Corporation, among others urged the government to bail out homeowners who were defaulting on their mortgages as well. While different policies of homeowner relief were considered the one finally adopted, Home Affordable Refinance Program—HARP, was modest and left Ms. Bair quite unhappy: “Shortly after Fannie Mae and Freddie Mac announced their new plan, Ms. Bair declared that it was inadequate and pointedly said that the government had spent hundreds of billions of dollars to bail out financial institutions like American International Group, the giant insurer.” “White House scales back a Mortgage relief plan”

From economists’ perspective, bailing out anyone creates a moral hazard. If market players profit from risky bets when successful but expect that the government will pick up the tab when they are unsuccessful, they will take greater (excessive) risks. No one was eager to bail out property flippers (those who bought property with the intention of reselling it at a higher price rather than move in) from their failed gamble. But the same logic applies to those financial firms that lent the mortgage money in the first place or that kept the financing cheap by providing it from the derivatives market of Mortgage Backed Securities, etc. Government policy makers attempted to design their bailouts to minimize the moral hazard they were creating, especially after the foolish and panic driven bailout of Bear Stearns in March 2008. But policy was driven by government’s fear of financial contagion.

The political optics of bailing out mortgage lenders but not homeowners is not good. Why did politicians choose to support one but not the other? Moral hazard is a problem with both. The reality is that Washington politicians were (are) much closer to Wall Street than to Main Street and are thus more sensitive to Wall Street’s concerns. Growing recognition of this fact adds some understanding to the hostile attitudes toward Washington expressed by Trump supporters.

By far the better policy would have been, and in the future is, to stick by the existing rules for bearing losses (our bankruptcy and default laws), i.e. no government bailouts. Our bankruptcy laws and procedures are actually quite good. “Resolving Failed Banks” For starters Bear Stearns shareholders should have lost everything. On the underwater homeowner side, mortgage lenders have always sought to minimize their losses when borrowers are unable to repay according to the original terms of a loan. Often the least cost resolution is for the lender to agree to easier terms and to restructure the loan. Evicting the “owner” and selling the property, especially when it is under water (i.e. valued at less than the mortgage amount), is a costly undertaking and writing down and restructuring the loan is often the least cost approach. However, government driven programs can rarely match the lenders’ ability to restructure loans one by one that can be honored by the homeowner while minimizing the loss to the lender. “Changing direction on bank regulation”

Our government has increasingly attempted to micromanage the private sector, especially the financial sector. This is a mistake. It should establish clear and pragmatic rules for conducting business and for resolving failures (workable bankruptcy laws). “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution and Ways to Overcome Them” Within this broad legal framework, which to a large extent already exists, individual firms would be held accountable for the conduct of their business by their customers and their owners. If they fail, the first losses must fall on the owners (shareholders), who have a greater incentive to do well and have better market information on which to act than do government regulators. This requires a change in attitude and direction of government’s role in our lives.

The Cyprus Game Changer

Early banks were established by wealthy men that depositors could trust to return their money when they wanted it. Bank owners had unlimited liability for the trust placed in them. Any losses that exceeded what the bank owed its creditors (primarily depositors) had to be made up from the personal wealth of their owners.

With the introduction of limited liability banks, bank owners invested in significant amounts of capital (the difference between the value of the bank’s assets and liabilities) to reassure depositors that the bank was safe. They also advertised the conservatism with which they lent and invested depositor money. Some countries granted bank owners a liability limited to double the capital they paid into the bank in order to increase depositor protection without tying as much money up in capital.  In the much of the nineteenth century in the United States banks held capital well above 50% of their loans.

These early experiences with banking without any deposit insurance or any expectation by depositors that someone would bail them out (repay their deposits) if the bank failed (failure was the result of the bank not having enough money to repay depositors), maximized the market’s discipline of bank risk taking. Depositors paid close attention to the safety and soundness of the bank they put their money in.

During the great depression, the U.S. and most other countries introduced limited deposit insurance for small depositors thought to be too unsophisticated to evaluate the soundness of their banks. Such deposit insurance pretty much eliminated bank runs by panicked depositors. The level of deposits covered by insurance has risen considerably in most places (in the U.S. it is $250,000 and in Europe €100,000) thus reducing market discipline to some degree.

But outside of the United States, where the Federal Deposit Insurance Corporation (FDIC) has broad intervention and resolution powers to take over insolvent banks and to keep them going (if that is the least cost resolution) by reducing shareholder, bondholder, and uninsured depositor claims, almost no country allows its banks to fail (though this has begun to change in the last decade or two). If a bank experienced large enough losses that it became unable to pay off its depositors (i.e. became insolvent), governments would almost always bail it out one way or another. Depositors never lost anything. This practice and the market expectation it created made a joke of limited deposit insurance (because ALL deposits were implicitly guaranteed) and significantly reduced market discipline of bank behavior. This required more active supervision and regulation of banks to take the place of market regulation.

After a very bad start in Cyprus last week (see my blog from last week: https://wcoats.wordpress.com/2013/03/23/cyprus-and-the-euro/) the resolution of Cyprus’ two largest banks, Cyprus Popular Bank and the Bank of Cyprus, is taking the form intended by the banking law. Rather than bailing out the bank (the Cyprus government doesn’t have the money to do so, hence its need to turn to external help –EU/IMF/ECB and to accept the conditions attached), the shareholders, bondholders, and uninsured depositors (in that order) are being bailed in to cover the losses. The insured deposits of the Cyprus Popular Bank, aka Laiki, will be transferred to the Bank of Cyprus along with good assets of equivalent value. Laiki, the “bad bank”, will be put into receivership and its uninsured depositors will receive whatever value can be realized from the sale of its remaining assets (they are expected to lose about 80% of the value of their deposits). The Bank of Cyprus, the “good bank”, will continue to operate but will be recapitalized by wiping out the shareholders, bondholders and about 40% of the value of uninsured deposits. Depositor risk and the market discipline it provides to banks has returned with a vengeance. Hopefully this will be the practice throughout Europe going forward, which could then stop ignoring its no bailout rule.

In a Financial Times interview Jeroen Dijsselbloem, the Dutch finance minister and Eurogroup chairman stated that: “If we want to have a healthy, sound financial sector, the only way is to say, ‘Look, where you take the risks, you must deal with them, and if you can’t deal with them you shouldn’t have taken them on….’ That’s an approach that I think we, now that we are out of the heat of the crisis, should consequently take.”

This is a very promising change in European attitudes. Sadly it shocked so many EU officials that Mr. Dijsselbloem had to back track by saying: “Cyprus is a specific case with exceptional challenges which required the bail-in measures we have agreed upon yesterday. Macro-economic adjustment programs are tailor-made to the situation of the country concerned and no models or templates are used.” (quoted in the March 26 WSJ “Shocked about Cyprus”) The big unknown is whether this was too rapid a restoration of market discipline. Changing the rules is always problematic and government explanations to their publics of the situation and their policies for dealing with it have been poor to date. The coming days will be interesting indeed.