Let the banks fail!

Freakonomics has one of the best analysis of the on going crisis, the bailout plan and the possible solutions, by Prof John Cochrane of the GSB, Chicago.

Prof Cochrane argues that any workable solution to the crisis has to take into account three factors - recapitalizing banks that are in trouble, including allowing orderly failures, and providing liquidity to short-term credit markets. The Paulson Plan addresses only the third, and that too partially, and will do nothing about the first two.

He feels that, as the business-as-usual buyout of Washington Mutual by JP Morgan shows, the financial markets have enough resilience to take in "orderly failures", provided the government can facilitate this process by marrying the operations of the failed bank with the capital of the new owners, if need be by "forced debt-equity swaps and various government purchases of equity".

He writes, "Let banks fail, but in an orderly fashion. When a bank "fails", it does not leave a huge crater in the ground. The people, knowledge, computers, buildings, and so forth are sold to new owners — who provide new capital — and business goes on as usual; a new sign goes in the window, new capital comes in the back door, and new loans go out the front door. Current shareholders are wiped out, and some of the senior debt holders don’t get all their money back. They complain loudly to Congress and the administration — nobody likes losing money — but their losses do not imperil the financial system. They earned great returns on the way up in return for bearing this risk; now they get to bear the risk."

The failures and mergers of weak banks, while hurting their shareholders and depositers (many of whom deserves to be punished), will end up removing the excesses from the banking system and also facilitate the market to recapitalize the remaining solvent banks. With the hedge funds and private equity firms relatively unaffected, and Sovereign Wealth Funds (SWFs) waiting with piles of cash surpluses, there would be no dearth of investors if these banks, especially the more solvent ones, are forced into issuing preferntial shares, and recapitalize themselves.

Given the huge reliance on short term debt, which banks keep rolling over on an almost daily basis, it is important that this market be adequately liquid. The collapse in confidence has had the effect of drying up even the short term credit to banks and opening up possibility of "runs" on bank deposits. In this context, the Fed stepping in as a "lender of last resort" and a temporary extension of the Federal Deposit Insurance to short term lending, contained in the bailout proposals, is an encouraging step.

The Paulson Plan hopes to generate enough momentum to catapult the sagging prices of these assets to profitable levels, recapitalize the banks and make them solvent agains. A tough order, since the $700 bn may be too small an amount to make any significant spurts in the values of most of these distressed assets. Prof Cochrane writes, "Never in all of financial history has anyone been able to make a small amount of purchases, establish a 'liquid market', and substantially raise the overall market price."

Update 1
Here is an analysis of the original Paulosn Plan by GSB economists.