Tuesday, January 13, 2009

A Proposal for the Economic Crisis: Establish New Banks

Officially, the federal government claims that very few banks have closed. If you're talking about formally chartered banks, that's true. Even if you count the close calls, like WaMu and Wachovia, which were acquired by other banks before they could collapse, the number of bank failures is relatively contained.

The reality, though, is that there has been a major collapse of the banking system. The securitization industry was a de facto banking system, which has almost totally disappeared as a result of the mortgage mess. This was multi-trillion dollar line of business, and provided a large part of the credit given to American consumers and industry. Scared straight by the disaster in the securitization market, large banks for all practical purposes no longer actively lend. They might retain existing loan relationships, but are often reducing credit lines for existing customers. New extensions of credit are very difficult to get, and usually are made only if the loans can be sold to the federal government. Banks themselves don't like to lend if they have to hold the credit risk on the loan.

Today, Federal Reserve Chairman Ben Bernanke said in a speech in London that more bank bailouts may be needed. This, on top of President-elect Obama's $800 billion plus stimulus package. Bernanke said banks might need capital infusions, and the federal government might have to buy toxic assets (the original purpose of Henry Paulson's TARP program, which he subsequently backed away from but perhaps should have implemented).

Let's face the facts: the banking sector has become a black hole that is soaking up taxpayers' money with no end in sight. It's obvious that the Fed and Treasury Department don't know how bad the problem is, nor do they know the magnitude of the taxpayer relief the existing banks might need. It's also obvious that the banking sector isn't about to return to real lending any time soon.

There is no way for the public to know how unclean the banking system's balance sheets are. Yet, an economic recovery depends heavily on a renewal of lending. Federal deficit spending might stimulate the economy for a while. But it isn't the self-sustaining kind of commercial activity that is crucial to a healthy economy. That requires a revival of lending. What we need are new banks. With pristine balance sheets, new banks would not be hampered by toxic assets and could lend based on reasonable credit standards. Their managements would not be concerned for career reasons about having to take write downs for bad decisions they made a few years ago, and would not need to hoard capital to cover losses from those bad decisions.

New banks would necessarily be small, which would mean they would naturally focus on consumers and small businesses, two groups of customers that have been squeezed out by existing banks. Small, new banks would be community oriented, and their localized knowledge would allow them to be more flexible with the smaller borrowers that default. New banks, being small, would not be too large to fail, so they wouldn't need the massive, unending bailouts that the mega-banks now receive.

Some of the second $350 billion tranche of the TARP money could be set aside to facilitate the formation of new banks and credit unions. This would involve the federal government holding an equity position in the new banks and credit unions, at least for a while. But better that than ever increasing federal equity positions in the too-large-to-fail banks.

As the new banks become established, they might well begin buying branches and facilities of existing troubled banks. In this way, banking resources could be transferred from poorly managed institutions which, in taking public assistance, have surpassed every welfare queen in America, to banks that might actually use those resources to benefit the real economy. If this slow motion process of restructuring the banking industry is taken far enough, the remnant troubled institutions might be allowed to fail (thereby turning off the spigot at the Fed and the Treasury), without seriously disrupting the real economy. That would be a good thing. When Sweden had a financial bubble burst in the early 1990s, it instituted policies along these lines, of forming new banks and allowing some troubled banks to fail. Its economy staged a good recovery.

The Fed and Treasury are spooked by the fallout from their decision to let Lehman collapse, which freaked out the financial markets and forced them to bailout the entire U.S. financial system. But they apparently have no strategies, policies, programs or proposals other than further bailouts regardless of cost. This must end; taxpayers, who do not have limitless resources, cannot indefinitely provide the existing financial system with a limitless line of credit. Banking isn't like an elementary school soccer game where score isn't kept. Banking is part of the free enterprise system and ultimately the score must count or the government has undermined free enterprise (and treated bankers like they're elementary school kids; but perhaps we should stop here because this analogy might be hitting too close to home).

Let's remember that the goal is to save the country, not the banks. To get around the black holes that existing banks have become, taxpayer money should be used to establish new banks and credit unions with clean slates for balance sheets. Then, credit might flow again to the real economy, and the entire society begin to prosper anew.

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