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Out With the Old Banks, In With the New

Friday, February 20, 2009

Creating new banks deserves to be a priority, but regulations make it difficult.

Two important things are entirely missing from Treasury Secretary Timothy Geithner’s “Financial Stability Plan” (FSP), formerly known as TARP. The first is any mention of encouraging the creation of new banks to increase the availability of credit; the second is any intention to reform the “fair-value accounting” fiasco.

Iconic investor Warren Buffett formed a new bond insurance company when the previously dominant firms were enfeebled by the losses on their unwise subprime credit bets. In the same way, now is a good time to start new banks, when many old ones are constrained by the deadweight burden of bad loans and unfortunate investments. It appears that the new secretary wants to call these “legacy” assets, as opposed to “toxic” ones, but the burden is not thereby reduced.

Which would you rather invest in: a new bank with a fresh opportunity to make loans and investments when interest rate spreads are wide; or an old bank sinking in bad loans and losses, entangled with the government as it acts as senior investor and “helper,” cuts executive salaries and forces loan modifications? The FSP includes an undefined concept of “public-private partnerships” to acquire troubled assets, but we can say that banks with troubled assets and TARP investments are already uncomfortable public-private partnerships.

Which would you rather invest in: a new bank with a fresh opportunity to make loans and investments when interest rate spreads are wide; or an old bank sinking in bad loans and losses, entangled with the government?

“Turning bad banks into good banks is…difficult and risky,” Paul Romer recently argued in The Wall Street Journal. “It’s simpler and safer to start entirely new banks.” He makes a good point. For one thing, with a new bank, nobody has to try to define the value of troubled assets, let alone set a price at which to sell them to the taxpayers. 

Creating new banks deserves to be a priority. But the February 10, 2009 American Banker gives a whiff of the reality, observing “how hard it is to win regulatory approval for a new bank these days” and “the long waits lately for regulatory agencies to issue charters and deposit insurance for start-ups.” 

It is easy to understand how regulatory agencies are completely distracted by their huge and widespread problems with existing banks. Likewise, one can see how from their narrow perspective, they would prefer all new capital to be devoted to restructuring problem situations. But from the broad perspective of the functioning of credit markets, new, unencumbered banks should be positively encouraged.

This has happened before in periods of financial stress. From 1932 to 1933, America was faced with a frozen and illiquid savings and loan industry. Mortgage defaults were widespread, refinancing of mortgages often impossible, and holders of savings accounts were often unable to withdraw their deposits, since their savings and loan had no cash. 

As part of the government’s response, the Hoover administration sponsored setting up the Federal Home Loan Banks, and the Roosevelt administration, the Home Owners’ Loan Corporation. But in addition, the Home Owners’ Loan Act defined a new financial charter: the federal savings and loan association. The government then promoted the creation of these new credit institutions across the country. 

The secret is that nobody can leverage capital like a bank funded with government-guaranteed deposits—provided the capital isn’t burdened with 'legacy' assets.

The government went so far in its encouragement as to match the capital raised locally to start federal savings and loan by the purchase of preferred shares. These shares had to be retired beginning five years later. (With this “new bank” strategy, even under Depression circumstances, in total the Treasury recovered its entire principal plus a yield of 3 percent.)

The Lincoln administration, in addition to fighting the Civil War, had to figure out how to finance it. Part of its response was also the creation of a new financial charter: the national bank. Under the National Banking Acts of 1863 and 1864, new national banks were promoted by the government and set up across the northern states, and ultimately, of course, across the reunited country.

It doesn’t seem that we need a new charter, although reducing the burdens of being a bank holding company could help widen the field of possible investors. A lot of new banks, some of them quite sizeable when capitalized by major institutional investors, would be very handy right now. The secret is that nobody can leverage capital like a bank funded with government-guaranteed deposits—provided the capital isn’t burdened with “legacy” assets.

The frightening downward financial spiral has been accelerated by the accounting rule-makers’ ideological faith in “fair-value accounting,” also known as “mark-to-market.” 

With a new bank, nobody has to try to define the value of troubled assets, let alone set a price at which to sell them to the taxpayers.

Many commentators have pointed out that this commitment of the accountants, who seem quite dug in, makes a down cycle worse, and that a market panic is the very time when “fair value” ideas have the least meaning. Recent examples: “Marking-to-market when the market is broken is impossible and results in the mess we now see;” and “Mark-to-market accounting...has created a disaster in America’s financial system.” (For further discussion of this issue, see my articles “No Fair” and “Fair-Value Accounting’s ‘Truth’ Is Dubious.”)

Secretary Geithner had a golden opportunity, which he did not take, to address reforming the “fair-value accounting” fiasco. It is to be hoped that he will take this up in the second chapter of the FSP.

Rational financial institution accounting would be another encouragement to create new banks and new sources of credit.

Alex J. Pollock is a resident fellow at the American Enterprise Institute. Previously he spent 35 years in banking, including 12 years as president and chief executive officer of the Federal Home Loan Bank of Chicago.

Image by Darren Wamboldt/The Bergman Group.

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