More Punditry On Next Steps for US Banks

The Wall Street Journal carried two editorials this week concerning the ongoing difficulties of the larger US banks. Specifically, Nouriel Roubini and Matthew Richardson, both of NYU, wrote on Tuesday that, at some point, "government has to show it can handle major insolvencies."

They also made the point that, thanks to overly-generous bailouts of equity investors in the past six months,

"The government has got to come up with a plan to deal with these institutions that does not involve a bottomless pit of taxpayer money. This means it will have the unenviable tasks of managing the systemic risk resulting from the failure of these institutions and then managing it in receivership. But it will also mean transferring risk from taxpayers to creditors."

Roubini and Richardson also note that current levels of several factors, unemployment being one, are already higher in actuality than in the stress test. So, what assurance do we have that these so-called 'stress tests' are really using stressful assumptions in the first place?

Wednesday's Journal contains an editorial by economist Glenn Hubbard and colleagues which argues the same point. They phrase it as a surfeit of carrots and a lack of sticks for bankers. Hubbard's piece follows with a fairly complex and unwieldy formulation of old banks, new banks, good banks, bad banks, and debt and equity holders swapping places in the various banks.

Contrary to Hubbard's contention that there is nobody left to buy a seized large, failed bank, I have argued in prior posts that such a contraction of existing, inept lending expertise should draw forth new, better-managed capacity from the likes of private equity and hedge funds. By purchasing problem assets on the cheap, buying branch systems and inheriting deposit bases, these new entrants would represent the first significant new capital to set up shop as large commercial banks in quite some time.

But what drew my attention, of course, is that both pieces begin by bemoaning the lack of bank closures, and too much risk being taken by the federal government on behalf of taxpayers.

It seems that more observers are concluding that the path on which our financial sector was placed last fall, beginning with the ill-conceived TARP program, has resulted in no normative measures by which to navigate subsequent developments. No banks apparently will be allowed to fail. Could this be why the market prices of so many bank equities have recently skyrocketed?

The implications are fairly clear. Even if the current administration continues to verbalize a reluctance to nationalize banks, its actions contribute to that effective result. No large commercial bank is seen as vulnerable to failure. Short-term trading as speculation is relatively safe.

By altering the normal path for failed banks, last used, or threatened, in the case of Wachovia, government has indicated that it sees bank insolvency as a temporary valuation mismatch, not a sign of ineptitude. Reality is being held at arms length by newly-improvised programs, tests and procedures so that no more large financial entities will be judged bankrupt.

Even if they actually are.

Somehow, this seems a recipe for disaster on a large scale. Rather like the Japanese approach to banking at the start of its infamous 'lost decade.'

Freely-trading capital markets are all about discovery of information and the accurate pricing thereof. How are markets to do that job when several large remaining banks are suspect of really being insolvent?