Beyond TARP

The Emergency Economic Stabilization Act of 2008 (EESA), which included the Troubled Assets Relief Program (TARP) as its core, has been voted down in the Congress. If one interprets this as a result of the Congress failing to act decisively, it is a bad news. But, given the problems of the TARP, this may be a good outcome, providing an opportunity for the government to come up with more effective plan to tackle the crisis. Acting quickly is important, as we learned from the past financial crises in various parts of the world, including Japan. The past experiences also tell us wrong moves just prolonged the crises. So it is worth spending a little more time to find the right solution.

Several years ago, Anil Kashyap and I examined the banking problems in Japan to come up with the right solution. (“Solutions to Japan’s Banking Problems: What Might Work and What Definitely Will Fail” in Hugh Patrick, Takatoshi Ito, and David Weinstein (Eds.) Reviving Japan’s Economy: Problems and Prescriptions. Cambridge, MA: MIT Press, pp.147-195, 2005. A working paper version of this paper is available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=622864)

Of course, there are many differences between Japan in the early 2000s and the current U.S. Just to mention a few, Japan had been in stagnation for about a decade; the U.S. financial crisis involves numerous new financial products that did not exist in Japan. But, the problems are similar at the fundamental level. The function of the financial system has been impaired after suffering from large but uncertain amount of losses. Then, any solution must include a resolution mechanism that identifies the amount of losses and determines who pay for the losses and a recapitalization mechanism. So, one should be able to learn some insights from the experience of Japan (or any other experience of financial crisis for that matter).

Our paper is long and contains a lot of details that may not be interesting for those who do not follow Japan. So here is a very brief summary of what our paper did.

We start by observing four basic problems in the Japanese financial system. The first is that most of the banks are severely under-capitalized when their condition is properly evaluated. The second is that the banks are not currently allocating credit efficiently, and instead are directing many loans to borrowers that will not be able to repay them. The third is that the banking sector is too large (in terms of assets) to make adequate returns. The final problem is that the banks’ lack of profitability is partly related to their inability to offer the high margin products that are commonplace amongst their foreign competitors.

We then explore the implications of these observations for the long-run equilibrium. A natural way to define the long run outcome is when the banking sector has shrunk to a level where it can profitably operate and the banks are once again adequately capitalized and no-longer ever-greening loans to deadbeat borrowers. Recognizing these conditions allows us to identify a set of issues that a successful policy must confront.

First, a successful policy must include recapitalization. There are some alternative ways to recapitalize the banking sector. One can encourage the banks to rebuild capital through accumulated profits. Alternatively, the regulatory agency can force the banks to recapitalize immediately. This approach can be classified further by the source of funds and by the required level of recapitalization. Looking at the source of funds for recapitalization, we can distinguish between recapitalization using private funds and recapitalization using public funds. The level of required recapitalization is the final critical parameter, and it can differ among alternative recapitalization policies. Banks could be recapitalized to the minimum necessary levels. Alternatively, banks could be required to raise their capital to a sufficiently high level so that they can withstand small adverse shocks without any additional assistance.

Second, a successful policy should stop ever-greening. There are two ways to approach the problem: one focusing on the banks and the other focusing on the borrowing firms. The bank-centric approach supposes that if banks can successfully get rid of non-performing loans, the incentive to keep ever-greening these loans will disappear. Loan disposal can be accomplished in several ways. One method is for the regulators to force banks to fully disclose non-performing loans, sell them in the market, and recognize the losses. Alternatively, or in addition, the government can set-up an asset management company to purchase the non-performing loans directly from the banks. Yet another bank-centric approach is to patiently wait for the banks to accumulate enough profits to write off non-performing loans.

The borrower-centric approach tries to stop ever-greening loans by making a case-by-case decision as to whether to revive or liquidate every weak borrower. A critical question under this approach is how many weak borrowers would be viable under normal macroeconomic conditions. If most firms would be profitable if normal macroeconomic conditions prevailed, large-scale debt relief may be sufficient to solve the current problem. If a substantial number of these underperforming firms would not be viable even under normal macroeconomic conditions, it is important to have a mechanism to sort out the borrowers that will be revived and the corporations that will eventually be liquidated or otherwise sold.

Finally, a successful policy should eliminate over-banking. There are several ways to do this. At one extreme, the government may wait for the banking sector to reorganize itself through voluntary mergers and acquisitions. At the other extreme is a policy to eliminate the over-banking problem swiftly by closing non-viable banks.

We compare these alternatives both theoretically and examining their successes in other countries. In examining the experiences in other countries, we relied on papers by Daniela Klingebiel and her co-authors (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=282518, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=282514, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=625254).

We point out the current Japanese policy is characterized by (i) extensive liquidity support for banks; (ii) guarantees to bank creditors; (iii) regulatory forbearance; (iv) the use of asset management companies to deal with nonperforming loans; and (v) repeated recapitalization. Charitably interpreted, this combination of policies can address the problems of capital shortage, ever-greening, and over-banking. In principle, the regulatory forbearance and the guarantee of credits give banks time to rebuild their capital base. In critical periods, the government also uses liquidity support and direct recapitalization. The banks can gradually remove non-performing loans from their balance sheets using asset management companies. With sufficient problem loans off of bank balance sheets and restructured, ever-greening incentives fall. When normal macroeconomic growth resumes, no new non-performing loans emerge, and the ever-greening stops. Over-banking is solved by restructuring of banks in return for public capital. Voluntary reorganization through merger and acquisitions also helps eliminate the over-banking.

Then, we argue that these policies have been in place in Japan and do not seem to have worked. Moreover, the experiences of other countries show that similar policy combinations were used in many crises and failed.

Based on these analyses, we recommend (1) strict bank inspections by the FSA with a consistent standard that closely monitors the health of borrowers and loan collateral; (2) restructuring of the bad loans and closure of the most insolvent banks; (3) selective and aggressive recapitalization for the healthiest banks to remove any doubts about the solvency of the remaining institutions.

Our paper finishes by illustrating how the alternative policies would work by examining the Resona Bank rescue case and the Mitsubishi Tokyo Financial Group and UFJ merger case, but I do not get into details here.

Interested readers can download a working paper version of our paper from SSRN or get a copy of the book cited above. The papers by Daniela Klingebiel and her co-authors are very useful, too. We can learn a lot about what a right solution for the U.S. would be by looking at experiences of other countries. (An interesting experience from Colombia is reported by Mauricio Cardenas.)

2 Responses to "Beyond TARP"

  1. Guest   September 30, 2008 at 3:03 pm

    TARP is presented with no oversight , no interference from anyone just give blank check to Paulson and the FED of 700 billion dollars and sayonara.What would happen in Japan if the Treasurer asks for 700 billion and you are not allowed to disturb them and you are not allowed to ask questions or investigate what is happening with the money?What would you think in Japan?Would you think that the FRB has become a government within a government with its own agenda?

  2. Guest   October 1, 2008 at 5:31 am

    The families that own the FRB take in a trillion dollars a year tax free. They were sppost to be monitoring the health of the banks. Let them pay for the bailout.