Tuesday, May 5, 2009

Dangers associated with Geithner bank bailout plan

The Geithner Treasury, despite all talk of stress tests, has sought to drip feed the ailing banks with TARP and other credit assistance, in the hope that the financial markets would soon recover and normalcy would get restored. The preferred stock route of government bailout seeks to retain the existing share holders and creditors, without the government taking any direct equity stake in the banks. The problems associated with this approach, as against the more interventionist nationalization approach, has been discussed earlier here, here and here.

It is in this context that Thomas Hoenig, President of the Kansas Fed, has added his voice in favor of a more interventionist approach. He advocates that the tax payer should be made senior to all existing shareholders, and it should determine the circumstances for both managers and directors. He suggests that, similar to what was done in Sweden in the 1990s, the "non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and re-privatised as soon as is feasible". He finds the following problems with the current approach

1. Certain companies have not been allowed to fail and, as a result, the moral hazard problem has substantially worsened, especially with the "too big to fail" firms.

2. The "too big to fail" firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised into becoming more economically and politically powerful. The CFO of Goldman Sachs admitted so much, while explaining Goldman's performance in the first quarter.

3. The US government has poured billions of dollars into these firms without a defined resolution process, adding to the national debt. The longer resolution is postponed, the greater the losses and the larger the debt burden.

4. As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role. This is reflected in the fact that its balance sheet continues to swell, which may compromise the independence of the Federal Reserve and make it more difficult to contain inflation in the years to come.

5. The "too big to fail" institutions will continue to exist, with all their system-threatening externalities. Ironically, despite all the knocks taken, they would have become even more powerful than ever. Systemic risks will get perpetuated.

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