Nemo alerted me (after in turn being alerted by Calculated Risk) to a recent paper by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, brilliantly entitled “Too Big Has Failed.” Here is an excerpt:
[T]he current path is beset by ad hoc decision making and the potential for much political interference, including efforts to force problem institutions to lend if they accept public funds; operate under other imposed controls; and limit management pay, bonuses and severance.
If an institution’s management has failed the test of the marketplace, these managers should be replaced. They should not be given public funds and then micro-managed, as we are now doing under TARP, with a set of political strings attached.
You could call this a free market argument in favor of temporary nationalization.
Here’s another:
[F]or failed institutions that have proven to be too big or too complex to manage well, steps must be taken to break up their operations and sell them off in more manageable pieces. We must also look for other ways to limit the creation and growth of firms that might be considered “too big to fail.”
And my favorite:
[S]ome are now claiming that public authorities do not have the expertise and capacity to take over and run a “too big to fail” institution. They contend that such takeovers would destroy a firm’s inherent value, give talented employees a reason to leave, cause further financial panic and require many years for the restructuring process. We should ask, though, why would anyone assume we are better off leaving an institution under the control of failing managers, dealing with the large volume of “toxic” assets they created and coping with a raft of politically imposed controls that would be placed on their operations?
This is coming from the head of a Federal Reserve member bank, not some blogger working on too little sleep. Calculated Risk speculates about the significance:
This strikes me as a break in the ranks, and although Hoenig is speaking for himself (not the Fed), this might indicate a change in direction.
The paper is only 15 pages and is very accessibly written.
The Baseline Scenario 
Here is a good counter argument to nationalization.
The fundamental issue is how to make sure bank managements make sound judgments going forward. Neither bringing in new owners or keeping old owners can ensure that. What is really needed is sound policy and oversight.
From a long term perspective, many other issues are really just noises that distract us from the problem at hand.
By the way, it may be a good idea for this great web site to work on the problem of rethinking the entire banking oversight infrastructure. The fact is the banking business will always try to maximize return and compete fiercely.
By the following:
“From a long term perspective, many other issues are really just noises that distract us from the problem at hand.”
I mean things such as: punish the management, punish the shareholder, protect tax payer money, and etc. are all noises.
Yes even protect tax payer money is noise when put into the greater perspective of a global crisis. On the other hand, I am not suggesting we don’t take some measure to ensure this. However, it is not a main consider.
We the tax payers are already the losers and should be the losers because 1)we didn’t make sure our government has the right oversight of the banking industry and 2)we happily participated in the excesses in the housing market when things are going well.
Hoenig does a great job in clarifying things in this document. It should be widely circulated. (And yes, it looks like he is getting adequate sleep or perhaps people in KC are blessed with an adequate amout of common sense.)
I agree with him about the misnomer….
“Many are now beginning to criticize the idea of public authorities taking over large institutions on the grounds that we would be “nationalizing” our financial system. I believe that this is a misnomer, as we are taking a temporary step that is aimed at cleaning up a limited number of failed institutions and returning them to private ownership as soon as possible. This is something that the banking agencies have done many times before with smaller institutions and, in selected cases, with very large institutions. In many ways, it is also similar to what is typically done in a bankruptcy court, but with an emphasis on ensuring a continuity of services. In contrast, what we have been doing so far is every bit a process that results in a protracted nationalization of “too big to fail” institutions.”
Isn’t the heart of capitalism competition?
If we have institutions that are too big to fail, isn’t that proof of insuffient competition in the industry affected to keep it healthy?
Was the break up of Ma Bell good for the communications industry and its consumers? It sounds like Hoenig is suggesting that we need to move promptly to clean things up, and then make sure we don’t allow financial institutions to become “to big to fail” again.
What utterly brilliant common sense! I agree, lets get going on this and get there as soon as we can.
Hoenig for Treasury Secretary, or at least speechwriter!
If the heart of capitalism is competition, the lungs must be forever-increasing quarterly profits. . .?
Doesn’t capitalism by it’s very nature demand winners and losers? And ultimately one winner with the rest ending up losers? And then even the winner loses ultimately.
I don’t see how one escapes this fundamental reality.
This appears to be consistent with the rhetoric we’ve been hearing for the last several months. The “TOO BIG HAS FAILED” paper, the bill introduced by Congress that would give the FDIC ability to borrow $500 billion, and the big spike in the counterparty risk index this past week (insuring 14 global financial companies) seems to point to some pretty major events coming in the next week or so.
The cure to this crisis is to lower the cost of life.
Current prices are based on an artificial purchasing power level that was maintained by excessive access to credit in unsustainable proportions to the issuer of said credit. The real purchasing power of Americans is much lower than it was recently, and prices must come down.
Since CEOs had no reason to fear poor performance of the corporations they ran thanks to their golden parachutes, the US economy (and all others like it) were driven by short term profit-making, and the fastest way to make profit on the short term is by flooding the markets with massive amounts of credit. Anything that would be unsustainable can be made sustainable for a longer period of time thanks to massive access to credit.
For example, if you give me $1M in credit, I can spend that $1M in the economy, effectively making people and businesses around me $1M richer. You, as a CEO, have no reason to fear the future impact of poor decisions such as a $1M loan to an individual or a corporation that has low chances of paying it back, because either way you’ll get your bonuses no matter how bad things get.
Pretty damn simple, but nothing is being done about this. Obama and Co., like everyone else, are trying to keep prices high by creating inflation and to force the financial sector to lend as much as it used to, so that ultimately the economy can roll again like it did during the past ten years.
Well though luck, but it won’t work. “Fool me once, shame on you, fool me twice, shame on me.” The whole market will return into a recession once we start to see the economy turn around, in half the time it took to get into this one. Everyone will recognize the signs we now know, and the economy will be unable to turn around for more than a short time.
The only way to get out of this mess for good is to head down where the economy is taking us, but make it a soft landing by putting our money in the right places, mainly: freeing up income for the middle class by all means necessary by lowering the cost of life.
Otherwise we will see inflation in prices, drop in wages and jobs, and crash.
Here is something to think about.
“No preference shall be given by any regulation of commerce or revenue to the ports of one state over those of another: nor shall vessels bound to, or from, one state, be obliged to enter, clear or pay duties in another.” [US Constitution, Article I, Section 9]
How much federal money has flowed into the fine state of New York in support of its banking commerce? Is that not preference? Wall Street is certainly a port of commerce as even the framers would understand.
If the states weren’t so dependent on the federal government’s printing press, they’d sue under this clause. The union was founded on the principle that no one state could co-opt the federal government so that it directs commercial benefits to itself.
From 10,000 feet it sure looks like New York is doing precisely that.
Sub species aeternitatis all sorts of problems have a different cast, but what you dismiss as mere noises are essential to the banks’ collective future performance.
Replacing management is necessary, though clearly insufficient on its own to turn the crisis around. At Citi and AIG management didn’t just fail, they’ve almost wrecked the global financial system. Time to go.
Shareholders losing money is a consequence of the risk of ownership. It’s not a good outcome, but it’s necessary. Perhaps in the future, shareholders will act more responsibly and demand greater transparency from management.
The final paragraphs slip rather too comfortably into the third person plural, and I dispute that “we the taxpayers” are the same as the “we” in 1 and 2. How is the average American in any way responsible for the lack of gov’t oversight and deregulation mania pursued by ideologically motivated politicians and bureaucrats? I certainly didn’t “participate in the excesses” and most folk I know didn’t.
I agree that reregulation is necessary to generate renewed confidence in the banking system, though for my money I want to hear more of what you call noise first.
What is written is something “obvious” and simple that a lot of economist and bloggers had already written many times. I would be more interested in the part of “bridge banks” as a potential step towards the creation of new good banks. From the head of a Federal Reserve member bank, one would expect more details than those found in the blogsphere. We all appreciate the potential change in direction, although this seems more on approach than in concrete steps towards solution of the problems. A good starting point.
Most opportune. Temperorary nationalization will give opportunity to cleanify the augean stable in our Banking sector. With regulations in place will make the people in the financial sector accountable and thus the national credit flow will start.
Since the government can legally take over the bank and wipe out the shareholders, why cant the government on, say a Sunday nite, temporarily take over a bank, call it CountyGroup, and strip out the toxic assets, with CountyGroup getting nothing for them (so the govt doesnt have to value and pay for them), then reopen CountyGroup Monday morning with new managment, some capital injection (for which it would get preferred or common shares, whichever is best), and all of its non-toxic assets, deposits and liabilities and with the shareholders of the old CountyGroup each being given the same number of shares in new CountyGroup that they held in old CountyGroup, which can then continue in business as a good bank, or, perhaps, even better, reopen with say, 3 new good banks, A, B and C, with the old shareholders getting equivalent shares in the new banks and everything equally divided into the new banks. The govt then doesnt have to run the banks and there is no nationalization problem as the new management is responsible to the shareholders. The toxic assets, which certainly have some value, are then placed into an entity called, say, CountyGroup Toxic Holdings LLC, owned by the govt, and held and sold over time as the market exists for them. If needed, the govt would guarantee some portion of the existing liabliities of the new banks and the govt would get to keep all the money made from holding and selling the toxic assets as a way of covering the costs and liabilities being assumed by the govt? Is there a legal impediment to doing this that I am missing? Or is there some financial reason why it would not work? In other words, if the problem is valuing and paying for the toxic assets, why not just take them for nothing from the banks that are in trouble because of them and avoiding the problem of paying too much, or too little?
It’s easy to say let’s nationalize the big banks, but maybe more difficult to admit part of the reason some of them are in trouble is because they took over other failed institutions at the REQUEST of the federal government. JPM’s takeover of BStearns was requested by the government to protect the US economy, likewise BofA’s takeover of MLynch and WellsF’s takeover of Wachovia. If the federal government pulled the strings that got the big banks into trouble by forcing shotgun, weekend mergers…..it seems odd to say that now the federal government should take over the operations of these large banks that they helped to get into this mess.
The argument against nationalizing banks is silly and self-defeating. The Obama Administration needs to stop worrying about inflaming unlicensed plumbers in Ohio, and start fixing the bank governance problem. Not only did incompetent bank management get us into this mess, the same bank management has squandered bailout money on bonuses and dividends. If President Obama wants change within the banking industry, he’d better have his representatives sit on the board of directors of these troubled banks, where they can significantly influence compensation policy, dividend policy, and executive personnel decisions. Sadly, his current strategy of “shaming” bank management is as bankrupt as the de facto bank balance sheets.
In the end, I’d like the federal government to restructure these “too big to fail” banks into smaller entities, and then resell the common equity when the markets recover. That is the only rational long-term solution.
Having read the entire paper – I’ll say two things: First, its good, and should be in Mr. Obama’s overnight breifing book if it isn’t already. Second, I wish more of my federal colleagues would learn to write that well.
We need to look at a larger grander historical perspective. The countries and societies that have flourished are those which have had ready capital for investment, research and housing. At this point we do not have this and all the bail outs in the world will not correct this basic economic fundamental.
The only reason to prop up the current banks in trouble is to protect current depositors and protect the FDIC from collapse.
If we take the same amount of money being used for the bail out and use the $850 billion for housing and commercial loans at reasonable rates we will have a long term solution to the housing and economic down turn. We can prop up banks as much as we want but if that money is not going back into circulation what is the purpose.
Housing values will continue to drop until there is a market for them. If I cannot get a loan it does not matter how bad I want your house.
The bail out is a short term bump until that money is gone and it will be gone. It is a band aid over a huge wound. It does not cure the underlying basic economic problem with is capital, we cannot afford to get this wrong and I think we have