Nov 17, 2008 12:49 AM
What If We Let The Banks Fail?
Since the beginning of the financial crisis, one of the things that has been most striking is the unanimity of opinion that large financial institutions cannot be allowed to fail. The conventional wisdom is so one-sided in this regard that nobody (that I’m aware of) has actually gone through the exercise of asking what exactly would be the result if we simply did nothing and allowed the banks to fail. Given the enormous costs we are incurring to prevent this outcome, we have to at least consider the alternative. Would it not be more economical to simply let any bank fail that can’t stand on its own and let the government print money to pay off all the claims of the FDIC?

In broad terms, the banking industry uses three primary inputs in order to fulfill its functions. These inputs are capital, information, and human resources. Obviously much of the first category has been destroyed, but capital can always be rebuilt in time. The other two categories of inputs are largely unaffected by the current crisis. The informational infrastructure of the banking industry is completely intact (and will almost certainly be improved upon as a result of the hard lessons we are currently learning), and the available human capital is undiminished. So, even if the greater part of the banking industry were to cease to exist, new institutions would spring up (and would employ many of the same people – hopefully a little older and wiser now – who staffed the old ones). What would be so terrible about that?

As with a dilapidated house, sometimes the most economical choice is to demolish the existing structure and rebuild a new one from the ground up. At least in this case you know where you stand and your costs are fixed. If you instead refuse to accept reality and go on pouring money into a terminally-flawed structure, there is no end to the amount of money that can be wasted in a futile cause. What if we spend trillions of dollars in an effort to save the banking system but the problems persist? What then?

Our financial authorities seem to be turning a blind eye to the most recent and instructive historical parallel to our current situation. Everyone makes comparisons between the current crisis and the Great Depression, but a more relevant and contemporary example would be the case of Japan in the 1990s. Japan experienced a massive real estate bubble in the 1980s during which the Nikkei stock average reached a high of around 40,000. In 1990 the bubble burst, leaving the Japanese banking industry in shambles. Now, almost 20 years later, the Nikkei stands below 9,000. One of the main reasons for such a protracted period of underperformance is that, rather than allow economic forces to run their inevitable course, the Japanese financial authorities spent years and years trying to prop up an essentially bankrupt banking industry. As a result, the economy remained mired in a recession for the better part of 15 years. Had the authorities simply acknowledged and accepted the bankruptcy of the banking industry and started from scratch, the length of the ensuing recession would almost certainly have been much shorter.

I recently had a discussion with a former colleague in the investment banking industry, and he argued that, in spite of hopes that we have already seen the worst and that things will now start to improve, many existing financial institutions are basically insolvent and will almost certainly get significantly worse. He gave two reasons for believing that the worst is yet to come. First, corporations which have been forced to raise capital quickly have sold their best assets first. This only makes sense, since these are the assets for which there are both demand and observable prices. What is left on the books of these companies is the most toxic, unmarketable assets. Many of these assets haven’t traded in months or years and are therefore marked at prices far above their current value. If these companies are forced to start selling off these lesser-quality assets, the write-downs incurred will be far larger than the ones we have already seen.

The second argument for believing that many institutions (especially hedge funds) are likely to fail has to do with the incentive structure facing the executives of these companies. An ironic consequence of the public outcry against excessive executive compensation is that the best and brightest in the business have greatly reduced incentives to stay and try to turn things around at their present companies. Their compensation is tied to the performance of their equity, and since things have already fallen so far, they know that even if they succeed in avoiding complete collapse, they will never cash in to the extent they had hoped. This creates a strong incentive to walk away and start fresh somewhere else. This trend is already underway in the hedge fund community, and there is no reason to think that it won’t accelerate. So, if we continue to bail out existing institutions, it is likely that we will end up with companies which have sold their best assets and lost their best people. This is yet another argument for taking our lumps now in order to prevent even greater damage down the road.

A final argument for allowing the banks to fail is the message that our current actions send to corporations of the future. If we go down the road of bailing out banks and insurance companies, what is the message that is sent to executives of the future? Businesses will believe that they can always rely on the government to bail them out as a last resort. In an industry that is already based on “playing with other people’s money”, this will almost certainly lead to reduced prudence and less responsibility. In addition, what does it say to non-financial corporations which, in spite of having strong core businesses, are being forced into bankruptcy? Why is it fair that those who caused the problems get rescued while those who were innocent bystanders are left to their own devices?

Conversely, if we simply allow companies to fail, the message will be unambiguous and salutary. Executives in the future will understand that they will suffer the full consequences of their mistakes and their very survival depends on responsible and competent risk management.

All of this is not to say that nothing should be done to support the existing financial industry, but given the enormous cost that is being absorbed by the American public, we owe it to ourselves to at least consider the alternative.

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