from Follow the Money

Not necessarily practicing what you used to preach ...

September 21, 2008

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Back in 1998, after Asia experienced a systemic banking crisis, the United States led a series of international working groups to develop best practices for handling future crises. One of the working group -- the second working group -- developed principles for managing a systemic banking crisis. The group’s recommendations included:

"Bank owners (holders of bank equity) should not be bailed out. They should lose their investments when banks are given public support, or their investment should be diluted through sales of equity (or some convertible instrument) to a government agency, which is then in a position to benefit and recover cots if the institution’s conditions improves."

See p. 43-44 of the pdf of the Report on Strengthening Financial Systems.

"The extension of guarantees should be strictly limited, possibly by class of institution, instrument and agent;

"Guarantees should always be given in ways to reduce moral hazard risk. i.e. providing an upside risk to the guarantor."

p. 41 of the pdf of the Report on Strengthening Financial Systems.

I doubt the Treasury’s recent guarantee of money market funds fully meets this criteria; very large investors in money market funds now have more protection than many depositors in banks. The US doesn’t seem to have been fully prepared for the contingency that the bankruptcy of a large investment bank would lead to a huge rise in the banks’ cost of funds and a run on money market funds -- a key source of financing for the shadow financial system.

Another recommendation, from the final G-22 report:

"The working group recognises the role of government in protecting smaller deposits in the banking system and the overall integrity of the financial and payments system. However, preserving the stability of the financial and payments system does not require protecting individual banks, their managers or their equity owners from the risk of failure."

See p. 8 of the pdf the Report on International Financial Crises.

These are difficult -- and, as Secretary Paulson noted, humbling -- times for the United States. But that doesn’t mean that existing equity investors in the financial system necessarily have to see their investment protected when the government injects additional funds into the system.

Full disclosure: I was part of the secretariat that helped to draft the Report on International Financial Crises, a working group the United States chaired. It was my first significant job at the US Treasury.

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