Sunshine for the Banks

By Anders Aslund
Friday, February 6, 2009

The United States is failing to handle the horrendous banking crisis. The Treasury and the Federal Reserve have sunk hundreds of billions of dollars into the banking system with no real solution in sight. This cannot continue.

The world has endured many large-scale banking crises, and the rules for survival are simple. Chief among them: Do not try to reinvent the wheel during the crisis but, instead, act quickly in accordance with tested principles. In the early 1990s, I lived in Sweden as the country went through a systemic bank crisis. Sweden learned much from the U.S. handling of the savings-and-loan mess of the 1980s, and the Obama administration should go back to those basics.

A banking system pumps payments through a market economy much as a heart pumps blood in a body. A banking crisis is a severe market failure. It devastates confidence. When banks fail, only the state can restore confidence in capitalism. All actions must be oriented to swiftly restoring trust between creditors and debtors. The means of doing so are clear principles, transparency and new capital.

With that in mind, the Obama administration should heed these five lessons:

First, clear and general principles must be chosen. Unfortunately, the Bush administration invented a new solution every time it saw the same problem: Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, Merrill Lynch, AIG, Citigroup, etc. This further undermined confidence. Such trial-and-error dilettantism must end. The Obama administration needs to choose a single strategy to address the meltdown.

Second, transparency is key. No bank that believes that it holds large bad debts will make new loans, and undeclared losses in the U.S. financial system are still conservatively estimated at $1 trillion. To restore trust, the government must force the banks to reveal all their potentially nonperforming debts and write them off. The problem here is not that assets have been "marked to market" but that huge bad debts remain concealed. Consultants unaffiliated with the banks should carry out this assessment so that it is done objectively. Informed by real numbers, the market will soon find its bottom, a necessary step for recovery.

Third, the nonperforming bank debts should be transferred to legally separate "bad debt banks" to relieve the ordinary banks of the burden. Only then will banks start making new loans. During the Swedish crisis, each big bank, whether healthy or insolvent, set up a bank to deal with its bad debts because management of bad debts differs from ordinary banking. It is better to have many small banks whose sole concern is bad debts rather than a huge aggregator bank because working out debt requires a lot of management capacity. So far, not one U.S. institution has set up a bank to handle its bad debts, and the credit market remains severely constrained.

Fourth, recapitalization makes sense only after banks' books have been cleansed. Put another way, the Troubled Assets Relief Program has largely been wasted. Both the ordinary banks and those that hold only bad debts would need to replace some lost capital. The government will probably have to provide that capital to the worst-off banks left in state ownership and temporarily help viable but weak private banks. After their balance sheets are cleared, the banks will become attractive to investors again. In Sweden, two big private banks were recapitalized by their shareholders, which proved highly profitable.

Fifth, do not force early sales of assets. One mistake of the Lehman Brothers bankruptcy and the AIG "rescue" was that both institutions were forced into fire sales of huge assets. By contrast, the Swedish bad-debt banks sold off their assets over several years, getting decent prices and not depressing asset markets. In the end, they actually made slight profits. Only one big Swedish bank was nationalized, and it was gradually privatized to generate maximum profit to the government. Although total bank losses were at least 12 percent of gross domestic product, the government intervention was fully repaid. The current U.S. financial losses, which the International Monetary Fund estimates at 16 percent of GDP, are worse.

When Sweden dealt with its bank crisis, it had a conservative government headed by Carl Bildt, now the foreign minister. It wanted to save and expand the private banking system, and it did, while minimizing public expense.

By contrast, the Bush administration's actions convinced the market that it had no principles, only personal relationships. Bad debts continue to weigh down the banks, which are hoarding the government funds that have been injected into them. Huge concealed bad debts are like a cancer that impairs the entire banking system, minimizing its lending and depressing its stock prices.

Only fools pour money into black holes. If the Obama administration wants to resolve the banking crisis, it needs to act more quickly and transparently.

The writer is a senior fellow at the Peterson Institute for International Economics.

© 2009 The Washington Post Company