Wednesday, January 27, 2010

The Prisoner's Dilemma in Banking

. Wednesday, January 27, 2010

Felix Salmon passes this along:

“A California Banker” writes to Mish, giving yet another reason why banks aren’t lending:

If you’re a bank with a relatively healthy balance sheet with adequate capital, (like us)you want to maintain surplus capital in order to stay on the FDIC’s list of banks they can transfer the loans and deposits from a failed institution into.

This is a home run for the acquiring bank and far more of an instant benefit than any new lending.

The problem here is that healthy banks end up competing with each other to have the largest capital surplus and therefore the greatest chance of being anointed in this manner by the FDIC. If everybody was lending, the FDIC would still have to place failed banks’ assets and deposits with someone. But instead we get the opposite corner solution, where nobody is lending — except, presumably, for banks which are close to failure and need all the interest income they can get. I wonder whether the FDIC has anybody thinking about how to counteract this syndrome.


Salmon calls this the "FDIC lottery" but I think a better name would be "Vulture-Banking": the healthy banks are waiting for the sick ones to die so they can acquire their assets at fire-sale prices.

It would be easy to counteract this syndrome: start taxing bank reserves instead of paying interest on them. But the authorities seem to be more interested in the short run in capitalizing the banking sector rather than really getting cash moving again. Why? Perhaps another post from Salmon could provide an answer:

My feeling is that the US poses at least as much of a risk to the global economy as southern Europe does. There’s a good chance that 2010 could be the year of walking away from underwater mortgages; there’s no sign of the private sector releveraging; and the government has clearly reached its limit in terms of the degree it can step in and borrow on behalf of the rest of us. If the attempt to prop up the still-overvalued housing market fails and there’s another downwards lurch, there will be a whole new wave of bank insolvencies and much less fiscal space to bail them out than there was pre-crisis.


Right. So if the regulatory authorities are thinking the same thing, they want to make sure there is enough capital in the banking system to keep banks solvent if there is another wave of writedowns in real estate. And if/when more banks do collapse, they want to make sure that other banks are healthy enough to absorb their balance sheet. The government either can't or won't pass another TARP-type bill, so the strength of the banking sector is essential; there can't be another bailout.

The downside to this strategy occurs when a cessation of lending slows down the economy enough to cause another downturn, which causes more foreclosures and walk-aways, which pushes more banks into insolvency. The regulatory authorities, however, apparently think that is a risk worth taking.

UPDATE: McMegan says this is evidence of moral hazard. I don't think so. I think regulators would like to see banks lending more, but they also want to boost capital reserves as protection. But they've incentivized the latter, not the former, and banks have responded accordingly.

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The Prisoner's Dilemma in Banking
 
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