Tuesday, 27 January 2009

The Good, the Bad .. Bank. It May Turn Ugly Too, Some Analysts Say

Watching CNN En Español last night, I learned that the proposal of creating a bad bank is gaining traction among analysts and government officials in the U.S. According to a recent JPMorgan Chase & Co. report, a bad bank would form part of a broader solution for the financial crisis afflicting America. But, what is a bad bank?

A bad bank would be a company that would remove the bad assets from the balance sheet of the financial system and manage them. The rationale behind this idea is that, if the financial system fell into a situation where the financial value of assets dropped below the value of liabilities, the social cost of reestablishing credit formation would be quite high. The payments and credit system would probably collapse. All that said, the creation of a bad bank would be desirable. But there are challenges facing policy makers who endorse that idea.

As JPMorgan puts it, ''removing bad assets from bank balance sheets may resolve some uncertainty surrounding the health of banks, but it is still the case that many banks will need more equity capital.´´ Last night, former Colombian Planning Director Juan Carlos Echeverri, speaking in CNN, suggested this idea as a sort of panacea for the current problems hampering the financial system of the U.S. He may be, not surprisingly, endorsing an incomplete idea. A bad bank doesn't resolve the problems of capitalisation facing dozens of financial institutions in the U.S. nor offers an automatic solution to the problem of pricing distressed assets that are putting balance sheets under strain. James Saft, the Reuters columnist, wrote about this issue yesterday in a piece called ''Nationalisation: Friend or Foe.´´ Click here to read his very insightful column. Thanks to Mr. Echeverri, we remembered to mention this issue in the blog. The debate is open. As Saft puts it, ''the betting is now that the U.S. will opt for some sort of a 'bad bank´aggregator which will buy up doubtful assets from banks, with the emphasis on keeping as many as possible operating as publicly traded entities which, once shorn of their bad debts, would be viable and would lend.´´ But lending in the current circumstances may not only be risky, but also imprudent.

If the bad bank idea is pushed forward, commercial banks and insurers may ''run a real risk´´ as the new entity would rid them ''of assets that are bad now leaving them (banks and insurers) to founder on new bad loans later.´´ Although the cases of Scandinavia, Mexico, Colombia and the U.S. itself (the HOLC of the Great Depression) offer valuable experience to deal with the vicious circle of bad loans, declining banking asset values, economic recession and government pressure to kick start lending, the questions remains on the size, extent and duration of the ongoing recession. The risk, Saft says, is ''that we could find ourselves in six or nine months in exactly the same situation, but with banks crippled by a new wave of defaults and with the non-financial economy in a much worse state.´´

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