With reports that the UK will invest $60.5 billion to take control of its four top banks, leading Western finance ministers left Washington with an important unanswered question: "What can we do that will restore confidence to the global financial markets?" I am heartened to learn the U.S. leaders are discarding their reverse auction strategy in favor of a plan to inject capital into our banks. But if that plan is not done the right way, it could be a missed opportunity of colossal proportions.
Here's what worries me about the current vague discussions. If the U.S. invests $700 billion in banks that apply for the investment, then the applications are likely to come from banks that are losing money and have the least amount of capital. If the Treasury invests in these money losing applicants, odds are good that they will keep losing money and the investment will be wasted.
In order to get a return on our investment, Treasury must follow a plan I called cull and capitalize. In this plan, Treasury would analyze our 8,400 banks and pick the winners. To do this, the FDIC could rank banks based on their profitability, their capital levels, and the quality of their assets. The banks that did not make it into the winner's circle would either be encouraged to merge with those winners or close down.
The winning banks would be required to hold at least a dollar of capital for every 8 dollars of assets -- a very high level of capital. (A year ago the typical investment bank carried a dollar of capital for every 33 in assets.) Such capital could be supplied by private sources -- potentially including private equity firms and hedge funds. And, to prevent these private sources from obtaining a controlling interest, taxpayer money would also be invested. If the economy recovered and the banks grew, the taxpayer investment could be sold at a profit to private investors in the future.
Why is this a good plan? Because it solves the basic problem facing the financial system -- which is that banks are afraid to lend to each other because they don't know if they will get paid back. The reason for their fear is that banks have seen how rapidly and unexpectedly the leading lights of the industry have disappeared over the last year. The cull and capitalize plan solves the problem by creating a small group of extremely well capitalized survivors who can be confident that they can lend and borrow from each other profitably.
Actually putting such a plan into effect will require some serious number crunching. However, the FDIC has all the data -- and the technology needed to do the analysis is a simple spreadsheet. However, once the FDIC crunches those numbers, it will need to send investigators into the top performing banks to assure that there are no hidden risks that should disqualify them from getting our money.
I think we're well beyond the point where we can allow political slogans -- such as the horrors of nationalizing our banks -- to keep us from putting a workable solution into effect. I hope our leaders seize this opportunity.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.
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Reader Comments (Page 1 of 1)
10-12-2008 @ 4:16PM
Anonymous Student said...
A better criterion would be whether or not that institution represents a systematic risk to the US economy. Going through and evaluating every bank in the country would take time and man-power when the credit markets need assurance, by tomorrow morning, that the major players are secured with government funds.
10-12-2008 @ 8:36PM
Bernard Thomsen said...
Dear Ladies and Gentleman. As the worlwide markets have been going on a "roller-coaster" the past 2 weeks with the best example of this on "black friday" I have a few questions. 1. Why is it, that knowbody has asked on your show or in any media, while billions of shares are being sold.......somebody is buying these shares. We are not talking about "petty cash" where these shares were sold....sometimes within minutes the markets dropped a few hundred points, while "mom and pup" in panic got out of the market....somebody bought all of these papers....this was certainly not those people who just sold them....so who was it? There are only very few entities able to buy such massive amounts.... a. banks ? b. governments ? or the OPEC countries with their petro dollars buying stock on the cheap to raise the falling oil prices again. 2. So the banking system needs a bailout? How is that possible....?A loss on the books of a bank, only is being realised once the bank starts writing of bad assets....so who told them to write it of....meaning why would you have to lower your value of your real estate assets if those assets have not even been sold....and in the congressional hearing everybody was talking about that knowbody knows about the value.So did these banks in fact do some write-offs? I don't think so.... 3. So billions of USD $ as well as Euros have been pumped into the banking system already....the fed windows for fresh cash have been opened for banks....but they have not been lending to each other....while this might be true ....there is still the questions where are these billions of dollars that have been pumped into the banking system in the last weeks...they certainly didn't make any special offers to the average person...?Could it be.... that these banks have startet to buy stock in the markets while the market "tanked" ....so later they can sell it back to the average "mom and pup" ?Wow....nobody has asked what the banks have done with the extra cash in the past weeks.... and now they want another few hundred billions in cash from the tax payer, so they buy everything on the cheap in the market, while everybody else is loosing their pants? Uncle Sam and the banks working together to "ripp-off" the average "Joe"?And now the governments in Europe do the same things, eventhough we had no lines in front of banks in Germany....trying to make us believe we have a crisis? I would call this a co-ordinated burglary on the way to the one-world government, while bankrupting the population of those countries. I would appreciate some of this being discussed on your program....some people might have a problem answering?
With best regards from Germany
Bernard Thomsen