This post first appeared in the Financial Times Economists Forum on February 9th 2009. I am reposting it here because it is as relevant today as it was then. My argument provides a way to provide a backstop to the banking system as a whole, without generating the incentive for any individual bank to engage in risky behavior and without putting taxpayer funds on the line.
By Roger E. A. Farmer Feb 9, 2009 @ 12:11
We don't need to nationalise the banks. We don't need to guarantee bad assets. We don't need government to own voting shares in private banks. We don't need to create a bad bank full of toxic assets. We just need a little faith in free markets and a little creative intervention. I propose that the central bank should support the price of an indexed fund of bank stocks.
The financial crisis that began in the US subprime mortgage market has spread far and wide. Between January 2007 and January 2009 the top 10 US banks lost two-thirds of their value as market capitalisation fell from $961bn to $333bn. The problem that began when investors were unsure of the value of mortgage backed securities has spread to corporate paper, credit card debt and student loans. These events are not confined to the US. The world financial system is hemorrhaging.
Before trying to solve a problem, it is a good idea to understand its nature. Investors in banks are not irrational. They are placing extremely low values on bank assets because they correctly assess that the economic situation can get much worse. The US economy is shedding 0.5m jobs a month and Europe, Asia and Latin America are not far behind. The loss in value of bank stocks is in danger of becoming a self-fulfilling prophecy as low wealth generates low demand and low demand adds to the unemployment rolls.
Free market economies need help sometimes. In every post-war recession the Fed has lowered the interest rate to restore private demand. That option is now unavailable because the interest rate cannot fall below zero. Policy makers are rightly considering a broader range of options. One option should be price support for bank stock. In a piece published on January 12 in the FT online, I argued for central bank support of a stock market index. A more limited version of this same idea provides a way for a central bank to inject new equity into its national banking sector without owning the banks or nationalizing them. How would this work?
First: Define an indexed fund that would include all publicly-traded bank stocks with weights based on initial market capitalisation. These weights could be revised periodically according to preannounced rules. Second: Allow private financial corporations to create and trade this fund by purchasing bank shares as assets and selling the indexed fund as a liability. Third: Direct the central bank to purchase an initial block of indexed funds - $300bn might be a good starting number for the US - and pay for it by issuing newly created short-term interest-bearing debt backed by the treasury but issued by the central bank. Fourth: At each meeting of the monetary policy committee, announce a price, and a rate of growth for this price, at which the central bank would be willing to buy and sell the indexed fund over the next few weeks.
How much would this cost? Let's take the US case and suppose that the Fed buys the fund at $10 a share under current bank capitalization. Now let the Fed announce that, one week from now, it will stand ready to buy or sell the indexed fund at $15 a share. The announcement will provide private investment companies with an incentive to buy the bank stocks that make up the index in order to profit from the Fed intervention. As these companies buy bank stock, the price of the stock of each bank in the fund will rise until their collective value is equal to the announced value of the index. This scheme recapitalizes the US banking system and could be implemented with little or no cost to the US taxpayer.
Banks are undervalued because there is no market for the ‘toxic assets' that they hold. How will the Fed decide on the correct value of these assets? It doesn't have to. The market will decide what they're worth. The relative price of each bank stock will be determined by marketplace trades and not by the Fed. As new information comes in about the underlying values of a bank's assets, the bank's value will rise or fall. If a single bank is found to have an unusually high proportion of toxic assets, market capital will shift to better managed banks. If a new bank is created, and is found to be efficiently managed, market capital will shift to the new bank and the old ones will fall in value or fail.
What are the advantages of this approach to alternative recapitalisation schemes under consideration? First: It need not cost the taxpayer a penny. Second: It allows the market to determine asset values. Third: It does not reward bad management but allows bad banks to fail without destroying the entire financial system. Fourth: It provides an incentive for the creation of new financial institutions to replace the old.
The world financial system is not illiquid: It is potentially insolvent. This is not a problem of bad fundamentals: It is a problem of market psychology. In the global crisis there is such a thing as a free lunch. By preventing meltdown of the world financial system we can get the global economy back on track. But to get there world government leaders and central bankers need to start thinking outside of the box.
Professor Roger E. A. Farmer is vice-chair for graduate studies in the department of economics at the University of California Los Angeles. He is the author of two forthcoming books on economics with direct relevance to the current crisis: Expectations, Employment and Prices and How the Economy Works