By William Isaac, Published by Forbes
We have invested billions of taxpayer dollars in the financial system over the past six months, but bank lending is not increasing significantly and the economy is continuing its downward spiral. Considerable damage has been done to the public psyche as we have careened from one crisis to another with little coherence in our strategies. People have lost faith in our financial system and our government.
It’s past time for our leaders to take a deep breath, calm down and unite behind a clear and comprehensive plan for restoring confidence. If they don’t, there’s little hope of putting the economy back on track any time soon.
There are four primary reasons why bank lending is anemic: 1) banks instinctively tighten credit standards when facing a recession; 2) banks have trillions of dollars of unfunded loan commitments so they need to husband their resources to meet those obligations; 3) regulatory models require ever-increasing capital and reserves in periods when losses are high; and 4) mark-tomarket accounting has destroyed hundreds of billions of dollars of bank capital.
The two most obvious changes that need to be made are in fact the least expensive and easiest to implement. So we need to act immediately to eliminate pro-cyclical regulatory and accounting requirements.
The Basel capital regime, imposed by regulators on the world’s largest banks in recent years, uses mathematical models to set capital standards. Models can’t look around corners, so they use past experience to predict the future, which makes them procyclical.
When we are in good times–say, 2005–these models see banking as an easy business that does not need much in the way of capital or reserves. When we are in times like today, the models develop an insatiable appetite for capital and reserves.
Mark-to-market accounting, imposed by the Securities and Exchange Commission and the Financial Standards Accounting Board over the past 15 years, is similar in its pro-cyclical effects. In good times, it inflates bank earnings and capital and fuels the boom.Now it is crushing bank earnings and capital, creating a downward spiral from which escape is next to impossible.
A recent report by the Group of Thirty, chaired by former Federal Reserve Chairman Paul Volcker, recommended that nations change these pro-cyclical policies. One can only hope the Obama administration will act without delay.
I opposed the bailout bill last October because I believed the proposal to purchase $700 billion of toxic assets from banks would be a colossal waste of taxpayer money. Banks would sell assets only if offered a good premium, and private sector investors would purchase assets only at a price well below the bank price.
So taxpayers would lose money on both the buy and the sell side unless the government held the assets for a long period, which would almost certainly result in substantial deterioration in value.
I favored then, and continue to favor, recapitalizing our banks. A dollar of new capital supports up to $10 in new lending, while a dollar of asset purchases supports only a dollar of new lending.
Thankfully, the Treasury used the bailout funds to purchase preferred stocks in banks rather than bad assets, but we still need to be smarter about this program going forward.
Banks that receive government capital ought to be required to commit to a reasonable amount of new lending. The capital should be provided to any bank that regulators believe needs the capital and will likely be viable. Banks should also be encouraged to seek out matching funds from the private sector.
The most important change I would propose, however, is investing the capital in common stock instead of preferred stock. The markets are not giving sufficient weight to preferred stock injections, apparently fearing the government will either nationalize or fail the banks if their common stock nears depletion. Some raise ideological objections, saying that we should not bail out existing stockholders by investing alongside them. While I would agree with that position in normal times, our priority today has to be to repair our financial system as quickly, simply and?cheaply as possible.
I’m not concerned about drawing the last drop of blood from bank stockholders, who could hardly be described as speculators or high rollers. Take a look at Citigroup. Its market capitalization has plummeted from $300 billion to $15 billion.
By adopting these strong, simple measures, we will get the banks back on solid ground so they can resume lending to revitalize our economy. Let’s make it clear that we are ending the financial crisis today.
William M. Isaac, former chairman of the Federal Deposit Insurance Corporation, is chairman of The Secura Group of LECG, a?financial services consulting firm headquartered in Washington, D.C.