How to Rescue the Banks
The Treasury secretary is now on the right track.
By CHARLES SCHUMER
Wall Street Journal, October 14, 2008
Treasury Secretary Henry Paulson's decision to make direct capital injections into American financial institutions comes as welcome news. And it is, as some of us argued all along, likely to be the most effective way to deal with the economic crisis.
This crisis is unlike anything we have seen since the Great Depression, and it is rooted in a lack of confidence in American and global financial institutions. As banks have taken huge losses, in part because of the bursting of the housing bubble, confidence has disappeared. Banks now no longer trust each other and have nearly stopped lending altogether. This threatens to bring to a halt our financial system, forcing us to act rapidly, if also wisely.
The administration's initial approach to the crisis was to propose buying troubled assets from banks. But direct capital injections into financial institutions -- modeled on the Depression-era agency, the Reconstruction Finance Corporation (RFC) -- always offered a far better prospect of success. The RFC provided fresh capital to banks and restored confidence (and lending) to the U.S. banking system, while making a small profit.
I pointed this out on the Senate floor a few days before Mr. Paulson came to Congress to ask for authority to spend as much as $700 billion to buy up troubled assets. Later, Democratic leaders Sen. Chris Dodd, Rep. Barney Frank and I made explicit our desire to make direct infusions of capital a part of the approach to solving the crisis during our negotiations with the Treasury.
The benefits of this approach are clear, which is why so many economists, both liberal and conservative, have embraced it. More than a liquidity problem, today we face a solvency problem. History has shown that under such conditions, the most effective means to restore health to the financial system is large injections of capital -- which only the government has the wherewithal to make.
Capital infusions are also far more efficient than purchasing assets. Banks can lend much more if their capital bases are restored, and when they dispose of their troubled assets, private markets, not the government, will fix the price.
There is little question that making the government a major investor in American banks raises thorny questions, especially about the role of the public sector in private markets. So let me be clear -- this is a temporary solution to an unprecedented crisis, and the government's role must be limited.
However, that does not mean the government should simply make investments with no or minimal restrictions. We must operate in the same way any significant investor operates in these situations -- when Warren Buffett invested in Goldman Sachs and General Electric in recent weeks, he demanded strict, but not onerous terms. The government must be similarly protective of taxpayer interests, without involving itself in daily operational decision making. I believe there are a series of steps and principles, both carrots and sticks, that must be applied if Treasury embraces this approach.
The government should encourage widespread acceptance of capital injections, and mandate it where there are clear systemic risks.
Direct injections of capital will encourage all institutions to lend again. But because depositors and creditors may interpret an injection of government capital as a sign of weakness, we need to start by persuading a substantial cross section of major banks, even those in relatively good health, to accept capital. Widespread bank participation will reduce the risk that depositors may flee or that other institutions will refuse to do business with banks that accept or request public capital.
The government must receive senior equity positions in any financial institution that receives public funding. Because taxpayer funds are being put at risk, the financial institutions that accept public funds must not be the only beneficiaries of the new capital. Requiring an interest, such as senior preferred equity, in exchange for capital will accomplish this. Banks will be paying for public funds while they use them, so they will have an incentive to use these funds wisely. And when the banks are in a position to redeem the preferred shares, taxpayers will be made whole for the money they have advanced.
One of the fundamental lessons from past banking crises -- most notably in Sweden and Japan in the 1990s -- was that government capital must be used to shore up the health of banks, not passed on to shareholders or executives. This means that under any capital injection plan that Treasury pursues, dividends must be eliminated, executive compensation must be constrained, and normal banking activities must be emphasized. There needs to be a clear stipulation for any institution receiving capital -- these are public funds to be used to restore the capital position of banks and foster lending, not to be hoarded or to be used for exotic financial activities. Alternative structures that ensure taxpayer protections, but which might under limited circumstances allow dividends to be paid, could also be acceptable.
Any banks that participate must be subject to enhanced scrutiny from the Federal Reserve and their primary regulator. For the financial system to be restored to good health, trust must be restored. This will only happen when banks and investors believe they know the real state of each bank's balance sheets.
Where possible, we should try to encourage private investment alongside public investment. A number of economists have argued that the government should use its capital infusions as a means to encourage private investors to make similar investments. While we should not make this a requirement, the Treasury should encourage such private investment.
Finally, as part of a coordinated effort to restore confidence in the banking system, the government should consider a temporary but significant expansion of deposit insurance, either for those institutions that accept capital injections, or all banks. The government should also consider temporarily insuring all interbank lending. But however we expand credit, we must be mindful of capital flows between domestic institutions and among international ones.
Mr. Schumer, a Democrat and U.S. senator from New York, is a member of the Senate finance and banking committees.