Defending A Peg: Lessons for the US Banking Authorities

You’ve seen it a thousand times.  A country’s exchange rate used to make sense, but now it is hopelessly overvalued.  And, consequently, your pegged exchange rate now looks like a one way bet.  Every Financial Times subscriber starts to think about how to either get out of your currency or, if they are feeling aggressive, how to more actively speculate that the exchange rate will soon depreciate.

And the beauty of this situation – from a speculator’s point of view – is that the relevant authorities will never move quickly or decisively to the inevitable end point.  Sooner or later, the currency will be devalued and, if the country’s citizens are lucky, sensible economic policies (and perhaps external financial support) will be put in place to support the new exchange rate.  But, for a surprisingly long time, the government will make statements along the lines of, “we will defend our exchange rate,” “we have plenty of reserves,” “we will never devalue,” or – my favorite – “the fundamentals are fine.”

This analogy sprang to mind when I read this morning’s joint statement by Treasury, the FDIC, OCC, OTS, and the Fed.

The U.S. government stands firmly behind the banking system during this period of financial strain to ensure it will be able to perform its key function of providing credit to households and businesses.  The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth…

Any government capital will be in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well-capitalized position and can be retired under improved financial conditions before the conversion becomes mandatory.  Previous capital injections under the Troubled Asset Relief Program will also be eligible to be exchanged for the mandatory convertible preferred shares…

Because our economy functions better when financial institutions are well managed in the private sector, the strong presumption of the Capital Assistance Program is that banks should remain in private hands.

This would be a fine statement in many contexts.  But there is now an obvious endpoint, which is very much on everyone’s mind – there is no point in pretending otherwise.  Either banks will be taken over by the government – and then reprivatized (and I insist on immediate reprivatization) – or they will not.  And “not” is fine with me, but this option is only persuasive if you can really explain how it is going to happen and provide a decent deal for taxpayers (given that this will effectively insure bankers’ bonuses).

I’m not saying there are any easy or attractive alternatives.  In particular, the lack of prior stress tests mean the government does not yet have full information on banks’ balance sheets (aside: what exactly have bank regulators been doing for the past two years?)

But this morning’s statement feels like another partial, vague, and underfunded commitment.  This does nothing to reduce uncertainty.  And, just like fears about fixed exchange rates in other contexts, this will undermine confidence in the economy more generally.  Whether it will speed or slow our movement towards the endpoint remains to be seen.


Originally published at the Baseline Scenario and reproduced here with the author’s permission.