- After the Fed bailed out Bear Stearns and arranged for its sale to JP Morgan, I blogged saying that the Fed hadn’t done the right thing, and was now creating a situation of moral hazard.
- When Lehman was in trouble, I said that this was a good time for the Fed to make amends for not allowing Bear to fail. Reputed commentors such as Michael Lewis backed up my claims (sorry, i’m too lazy to find links). And the Fed seemed to take our suggestion. And Lehman was allowed to fail
- Now, following Lehman’s collapse (and I’m not sure if there’s a causality here), the entire global financial system is in trouble. No one is lending to each other (remember that in my original post I had said that the point of removing the moral hazard is that no one will lend to bad banks. Based on that it’s like as if all banks are bad now). The remaining banks are going down one by one.
- It seems like the Lehman collapse is just a small part of the larger picture, and if things continue to go bad the way they’ve been, it’s even likely that the impact of the Lehman collapse will not be major compared to the total size of the crisis.
- So the real danger is that by the time the crisis is over and everyone has recovered (it’ll take a long time indeed for this to happen), people would’ve forgotten about Lehman. Forgotten that banks are not necessarily too big to fail (and given how bad things have got, the Fed cannot allow more banks to fail). Forgotten that no one will bail out the creditors if someone in the system tells jai. And people will go back to their old bad habits
- Important question to ask here is the role of the Lehman collapse in the magnitude of the current crisis. There definitely has been some impact, but it would be interesting to see exactly how much. Would this collapse have been as bad had Bear been allowed to fail when it was about to fail? How much incremental damage was done to the system in the six months between the two major ibank failures?
- In hindsight it seems like the Fed might have done better in letting Bear fail rather than letting Lehman fail; actually we aren’t even sure of this.
- The question remains as to how discipline will be ensured in the system, without too many restrictions, once the system is back up on its feet (it’s going to take a long time, mind you). Maybe we will see smaller banks. Large networks of smaller banks, with none too big to fail. Yes, there will be continuous churn, wiht banks failing continuously and new banks coming up to replace them. Banks will be more ruthless in dealing with each other.
- But how does one ensure that the system goes into this particular steady state, and not any other, once it’s back up?
6 thoughts on “The ibank bailout”
Large networks of smaller banks – are you talking about real banks or i-banks here?
normal banks don’t lend that much to each other, do they? wait i’m confused now.
This is what Jayanth Varma was talking about da. The interbank rate is high now because even regular commercial banks aren’t lending to each other.
And death is happening in Iceland because their normal banks are too small – not enough of a deposit base to cover their obligations. This was also why the savings and loans crisis happened in the US in the 1980s – banks were so overregulated that they couldn’t grow enough and each individual bank didn’t have enough deposits to sustain against a run or bad loans.
Think the issue is not size as much as leverage.
agreer that there shouldn’t be any regulation on size. what i’m saying that regulators should make it clear that no one is too big to fail. let people grow as long as they can take care of themselves.
and when everyone knows regulators won’t bail out the banks, they won’t let someone grow too big unless they know they are doing it in a sensible way
Not sure if bank balance sheet size is an issue. Banking is a basically unsound business owing to high leverage and maturity mismatch of assets and liabilities. I suppose there is no way out since most ppl want to borrow long and lend short.
Yes, high leverage and maturity mismatch (and hence liquidity – Less liquidity and tight credit make the perfect recipe for disaster) seem to be the two fundamental problems.
Regarding Lehman, it is my unbiased view that they should have been saved. Two reasons
1. Exposure to Lehman
The total exposure to Lehman is much higher than the exposure that would have been to Bear. Right after Lehman fell, the biggest worry was exactly this – Starting from the CDS exposure to Lehman people had. It seemed to many that the 70 billion aid to AIG was exactly for this – AIG was the largest seller of Lehman CDS. CDS contracts of Lehman were quoted at a scary 240 billion notional; however DTCC came clear and said many of the positions are expected to cancel out leaving only 6 billion as the net payout. That reduces fears drastically – Imagine AIG having to pay out 50 billion on CDS settlements (Oct 21st is the settlement).
2. Preventing massive asset deflation – Which could lead to lesser lending – recession
When asset prices were deflated, banks, I would say realized two things:
a) There would be write downs
b) These assets were bought at high levels of debt (or leverage).
So assuming these asset prices did NOT go down, it would have been perfect for banks to sell these assets off, deleveraging. All banks started to deleverage, selling off these assets, and people believe this led to what’s called the paradox of deleveraging (In effect, the paradox of aggregation which states that if everybody saves, people are worse off than earlier because then nobody earns) which implied that everybody deleveraging brought the asset prices further down and didn’t quite deleverage to a large extent. In such a scenario, it was believed that the only way this could be stopped was if someone was to lever up their balance sheet with these assets with some hope of selling it later – Could be Fed, Treasury, whoever. (Keynes)
The only concern is that, since so much of tax payer’s money is being used right now, it should be done in the right way, and it should turn out for the taxpayer’s own good.
I still wonder if Paulson should have asked himself this simple question, thinking at the margin – What will happen if Lehman is not saved? Will we be worse off than if we did? The answer may not have been so simple.
What do you think, Wimpy?