Perspectives from ISB

Associate Professor of Finance and Business Economics (tenured), Marshall School of Business, Previously at the Board Governors of Federal Reserve System, International Monetary Fund

This is a part of the MCC’s Exemplar Series, where each week, we shall seek to bring to you the best thoughts out there and seek to stir a debate on matters in the material world, so to speak.

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It’s great to have you here with us Sir. Today, we want to pick your mind on Global Economics, with emphasis on the first half of the year, and how it has gone by. We have completed a course in Global Economics, and have a new found curiosity in the post 2008 crisis world. What’s your take on the Banks in US right now, and your thoughts regarding the current regulatory environment?

Professor: I think the two main sources of regulation that the US has pursued is asking banks to have more capital so that the losses can be better weathered, and the insistence that banks have more liquidity. If Banks are holding more liquid assets when the depositors come to withdraw, the Banks will have enough cash. I believe post crisis there has been more push in these two areas. If you are forced to have more liquid assets, then there will be less funds available for loans. And this certainly has been the case that lending post crisis is lesser than pre crisis. But that does not mean that it is sub-optimal.

My intuition is that the last thing one wants is a replay of the crisis, as the US and the World does not have the capacity to have a fresh bailout to meet a new crisis. So, if one has to err on the side of caution, now might be the best time for it, so that economies can rebuild themselves. The EU for example, has just allowed the Italians to close one of their big banks, and as they are still dealing with the last shock, the last thing one wants is for the US to do away with regulations.

Coming to India, where there is a talk of bad bank, to address specific challenges the economy is facing. What’s your outlook on this? Should a developing country like India looking at such a solution?  Or is it just administrative in nature?

Professor: The bad bank idea came about with the Great Depression. In the 1930s, the US had massive amounts of bank failure due to a lot of assets that fell in value. When the banks failed, the local governments tended to sell the assets quickly, and the externalities from the fire sale led to other banks also failing, as the value of marked to market assets shrink when similar assets are owned across banks. And this contagion effect made matters worse!

So I think what the idea is about is that it takes the bad assets out of the market. And if a bank is failing, I can move my bad assets out and revitalize it with fresh equity. Once the balance sheets become cleaner, I can go lend again. Concentrating the assets out of the banks and into a single bad bank means no liquidation pressure – there is no fear as to my equity holders that the assets need to be sold off quickly.

Secondly, it gives the owner of a bad bank (critical) time to find the right sets of buyers that can put these assets to their best use. These buyers need not be Indian buyers. They could very well be private equity players who know how to say, run an airline. They have done the same thing countless times in the US and Europe where turnaround happens – due to their (management) expertise in running them. What then happens is that there is a best deal available with no pressure to sell them fast. The wrinkle in all of this, is that this process needs to be insulated from politics. If the Govt. gets involved in a non-economic way, then a market efficient outcome may not be likely.

To pick an example, suppose this happens in the US, and the bad bank has been created and is being housed in a committee run by the senate.  And then a Senator has friends who know about these assets and would like to buy these assets.  The senator may say that if you make a contribution to my campaign, I can pick up the phone and ask for these assets to be sold to you at a real big discount. Then, one has problems, as the taxpayers may not end up benefiting. So essentially speaking, these sales have to be very transparent, maybe with open bids and people need to trust the process. There has to be a right mechanism to pick the bids, avoiding the cronyism that is at risk.  It must not become a political game where those with friends in high places end up benefitting the most.

Interesting. Although it could work in India, we would like to know examples of this, has this worked in the past?

Professor: I have two examples to my memory. First, the Reconstruction Finance Corporation, started in 1935 by the then authorities was aimed to do exactly this – to buy up all the bad assets of the banks in US, and the RFC did do a pretty good job in preventing a fire sale and helping the banking system heal. The research regarding this suggests that at the time, the process of insulating them was done pretty well.

The other one was the savings and loan crisis in the US in the 80s and the Congress set up a bad bank to dispose these assets beginning in the 90s. This is where I would ask you to check up online, especially on the Keating 5 scandal, where 5 US Senators were accused of corruption in 1989. And that’s where the cautionary tale comes in. The Fed in 2008 stepped in, for example, and bought the assets, and set a floor price to dispose of the assets. As the prices were plummeting, the Fed effectively set a floor price. For the mortgage backed assets, the US Fed became the largest buyer.

So what are the new regulations post crisis US is proposing?

Professor: Some in the US were unhappy regarding the Fed stepping in to buy these assets. The Dodd Frank Act was passed after much debate. The new regulations required banks to write a living will. (Essentially speaking), you need to write down while you are still alive, who will get to have these assets in case you do not survive. The credibility of these will get tested only in a crisis – whether or not this leads to a fire sale again, we are yet to see. Couple of things here. We have no way to judge the efficacy of these in good times, and when times are bad – and if the designated buyer is not in a shape to buy it, what happens then? Dodd Frank limits the ability of the Fed to do this, as it will not be legal anymore for them to buy assets.

Is the answer then to reduce the size of banks so that the risk of spreading contagion is limited?

Professor: So the answer here is that there is no answer! Every answer has a cost. And if it was easy, it would have been done already. If you reduce the size of banks, you do make the system more resilient. But, there are other costs. For instance, take GE, a big corporation. If all the banks are small, where would GE go to get loans? Banks have gotten big because firms have gotten bigger. If you limit the size of banks, you limit corporation growth, and economic growth.

A tough situation indeed. Coming to the current US administration – they have promised a lot of economic stimulus. Do you feel they will provide what is required to drive the economy? How do we see steady growth?

Professor: I think the conventional view now is that it is unlikely Mr. Trump will get much out of Congress. His ability to get more out of the congress is limited despite Republicans controlling majority of the Congress. He does have a very short window, as there are midterm elections next year. And if the Democrats come back and take the House, there will be a slimmer chance of him getting anything done. So slim chances of getting the stimulus he promised.

Professor, last question here. Coming to China, their system has a lot of debt, and there are concerns about the shadow banking system. There is a cloud that we have over the data from China, and in light of this, how do you see Chinese growth? Will it be the next fault line, so to speak?

Professor: So, I think we have a lot of evidence now that significant increase in leverage in this case can be problematic and even one spark can lead to a lot of damage. The Chinese authorities are aware of that. The mitigating factor is that the central government has the potential firepower to address any spillovers from a debt overhang, if there are any. Note here that we don’t know for sure that there are problems, but that is a saving grace.

Also, the Chinese Government has shown its capability in its past to handle economic challenges well, and that is reassuring. Now if you ask, is there a debt crisis in China? Well there is a lot of debt there, and that is for sure. But the magnitude of impact is hard to say. Future Chinese growth will depend a lot on their politics, their execution of policy, etc. No one can give a definitive answer to this.

It was an absolute delight to have you here interacting with us, Sir.

Professor: Ah thank you, you guys have been patient listeners!

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