Still the Best Plan for Fixing the Banking System

Mon, 23 Mar 2009 18:08:49 +0000

This idea by Jeremy Bulow and Paul Klemperer is still the best one I've seen for how to reorganize the banking sector without massive infusions of taxpayer dollars. (See this earlier description). Here is the summary:

  1. We cannot efficiently value or transfer “toxic” assets - so a good plan cannot depend upon this.
  2. The UK’s Special Resolution Regime, or one similar to that of the US FDIC, can cleanly split off the key banking functions into a new "bridge" bank, leaving liabilities behind in an "old” bank, thus also removing creditors’ bargaining power.
  3. Creditors left behind in the old bank can be fairly compensated by giving them the equity in the new bank.
  4. We can pick and choose which creditors we wish to “top up” beyond this level, but should not indiscriminately make all creditors completely whole as in recent bailouts.
  5. Coordinating actions with other countries will reduce any risks.

The key point is the first one -- too much of the Obama Administration's plan is focused on so-called "toxic assets." Risky assets should be held by equity holders -- they should not be held by the government, nor should the government be subsidizing their purchase. These distressed institutions already have equity holders. What is needed is simply a mechanism to match the insured liabilities with the highest quality assets. This is such as mechanism.

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