Start New Banks
In the discussion section of Steve Verdon’s Obama the Fear Monger post, commentor Drew and I had a brief debate about the possibility of using TARP funds to create new banks rather than try to rescue old ones. In today’s Wall Street Journal, Paul Romer of the Stanford Institute for Economic Policy Research makes this argument as well, with more sophistication than I could muster. The core of his argument is:
The government has $350 billion in Troubled Asset Relief Program (TARP) funds that it can use to encourage new bank lending. If this money is directed to newly created good banks with pristine balance sheets, it could support $3.5 trillion in new lending with a modest 9-to-1 leverage. Right out of the gate, the newly created banks could do what the Fed has already been doing — buying pools of loans originated by existing banks that meet high underwriting standards.
If the TARP funds go to existing banks, much of them will end up stuck in financial institutions that are still bad after the transfer. We know from the previous round of TARP that giving more capital to bad banks generates very little net new lending.
Proposals for turning existing banks into good banks — recapitalizing them, nationalizing them, transferring the toxic assets off their balance sheets, or insuring the toxic assets — require prices for all these hard-to-value assets or, worse still, prices for derivative contracts on the toxic assets. (Calling the derivatives “insurance” doesn’t make them any easier to price.) Without reliable market prices for the hard-to-value assets, any proposal for turning bad banks into good banks could lead to huge transfers of wealth between taxpayers and bank shareholders.
Since I was proposing this as well, I obviously agree with the sentiment. The key question is whether we think it is even possible to salvage some of our large troubled banks. If it is, then it probably makes sense to do so and tap into their existing relationships and expertise (tarnished though it is). But if you think — as I do — that they cannot be saved given the finite resources that can be committed due to political constraints, then this approach, as ugly and messy as it seems may turn out to be the most promising.
Hat tip: Matt Yglesias