Evaluating Good Bank/Bad Bank, Banking Bailouts, etc.

Good ten-year-old paper I hadn’t seen before from Wharton evaluating the options for resolving problems in banks (and banking systems). Despite being a decade old, it has some solid reading as we work through the problems in the U.S. and global financial system.

The following paragraph on the RTC experience during the S&L crisis struck me in particular:

Total cost of the Thrift Crisis has been estimated in the neighborhood of $150 billion. Regulatory authorities were clearly unprepared for the magnitude of the Thrift Crisis. Costs were multiplied by initial inaction and bureaucratic inefficiency. There was a steep learning curve which by the 1989 creation of the RTC began to level off. Unlike countries that subsequently experienced similar problems, the US was fortunate that the thrift problem was small in relation to the total size of the financial system.

Sound familiar? It should — except for the last sentence, which is, unfortunately, not true in the current crisis.

Be sure to read this too from the conclusion:

If there are lessons from the experience, several come to the surface:

  1. Costs of intervention are generally larger than anticipated;
  2. Interventions aimed at preserving the current institutional structure generally do not achieve the expected outcome;
  3. The only sure resolution appears to come from confronting the insolvency directly and addressing its financial implications, no matter how large.

Regulators, however, often delay action in the hope of a turnaround. If the regulator is lucky, a change in the aggregate economy will remedy the financial imbalance. However, regulators are rarely lucky, at least in recent history. Resolution options available to regulators only permit them to delay the effects of a massive asset valuation change on bank structure in the hope of a return to financial viability. If they do not set off a series of counterproductive incentive effects, they may offer both the regulator and the bank manager time to shore up balance sheets and improve profitability. But, they offer only a little time and often require considerable luck. If the banking system can not correct its problems in short order, as was the case in the US Thrift Crisis, or if the economy continues to deteriorate, as in the Scandinavian case, or if the losses are too large, as in France, the policy will not achieve its end. On the edges these policy options may offer some hope to sustain the institutions’ lending capacity and consumer confidence for a short period of time. However, in the end, all of these options are no replacement for sound bank management and a sound balance sheet.