8/15/11 - keeping banks lending in a financial crisis

In today's excerpt - in a banking crisis, such as the one the U.S. faced in 2007/2008 and whose troubling after-effects remain, there are two critical items to manage. The first is that if a major financial institution fails, its operations continue so that counter-parties are not damaged and confidence in markets is not destroyed. The second is that if major financial institutions are saddled with huge numbers of bad loans, regulatory solutions be applied that allow these banks to continue to make new good loans. In the Latin American debt crisis of 1982, this second item was managed so well that few even remember the crisis. Similarly, in the Continental Illinois (Penn Square) crisis of 1984, the first item was so well-managed that markets were minimally disrupted. In the current crisis, neither item has been well-managed, leading to both the era-defining disruption of the Lehman failure and the continued hobbled operations of some of our largest financial institutions:

"Indefensible policy mistakes by Treasury Secretary Henry Paulson in his handling of Lehman Brothers and AIG severely damaged the credibility that eventually forced the Bush administration to recapitalize the U.S. banking system. ...

"[This contrasts sharply to Federal Reserve Chairman Paul Volcker's handling of the Continental Illinois crisis.] When Continental Illinois Bank collapsed in 1984, ... Volcker immediately asked J.P. Morgan to arrange a 'convoy' of banks around the institution [to provide liquidity and] prevent money from fleeing. Less than 48 hours later, the bank was nationalized. Although Continental Illinois was one of the nation's leading money center banks, proper handling of the nationalization process by the regulators prevented major problems.

"Inexplicably, however, Mr. Paulson decided to let Lehman Brothers fail, indicating from the start that he had no intention of using public funds to rescue the institution. Although Lehman Brothers was not a commercial bank, and the Fed and the Treasury were not obliged to save it, Paulson's stubbornness was in a sharp contrast to the Fed and the Treasury's efforts to minimize disruptions from the collapse of Bear Stearns, another securities firm. ... Lehman was a global financial institution, and thousands of investors and institutions around the world were left high and dry. The resulting anger went a long way toward destroying the credibility of U.S. banks, U.S. Bank regulators, and the U.S. government. And the rest is history. ...

"In [past crises] in the US, authorities successfully maintained lending functions of the banks when they were saddled with huge amounts of NPLs [non-performing loans or bad loans], for example, during the Latin American debt crisis, which erupted in 1982. In this crisis the U.S. had to move slowly because the vast majority of U.S. money center banks were technically insolvent and shutting down the entire banking system was not an option. With so many international banks also involved, the Fed had to be very careful in managing the crisis to ensure the continued functioning of the banking system and prevent negative fallout for the economy.

"[Federal Reserve Chairman] Paul Volcker ... handled the situation masterfully. Although the process eventually took a dozen years, it was done without a credit crunch and at no cost to taxpayers ­in contrast to the $160 billion bill for the cleanup of the S&L crisis, which was only a tenth the size of the Latin American debt crisis. Ironically, the Fed's response was so elegant that few people are even aware of it. Many may have heard of the crisis, but the authorities' deft handling of the situation received little public attention because no taxpayer money was required or requested. Further, no one involved could talk about it while events were still unfolding -- certainly no one from the New York Fed or the technically insolvent money center banks. Nor was anyone interested in hearing about it once the cleanup was over. As a result, some of the key lessons learned from this episode are missing from the current debate on how to handle the banking crisis."


Richard C. Koo


The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession


John Wiley & Sons


Copyright 2009 by John Wiley & Sons (Asia) Pte., Ltd.


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