Poole’s Market Solution to Fix Banks
Former Fed Governor William Poole
Here is a proposal, not at all original but deserving of serious public discussion. As a condition of enjoying the benefits of a bank charter, every bank must issue 10-year subordinated notes equal to 10 per cent of its total liabilities. The specification can be adjusted, but this one serves to illustrate the proposal. The subordinated debt would be unsecured; holders would stand last in line among all creditors in the event that a bank had to be shut down. The sub debt requirement would be in addition to existing requirements for equity capital.
Genuine reform requires that four minimal requirements be met, and the sub debt proposal qualifies. First, banks need more capital to protect the federal deposit insurance fund. Second, there must be more market discipline: each bank would be forced to roll over maturing sub debt equal to 1 per cent of its liabilities each year. Third, financial stability requires that a bank not be subject to runs. Sub debt cannot run, because of the 10-year maturity.
Fourth, and critically important, some creditors and not just equity owners must be at risk, which is clearly the case with sub debt. Sub debt provides much more market discipline than equity, because a bank in trouble with a weak share price is not forced to do anything. Maturing sub debt, however, does discipline the bank and if the bank cannot roll over the debt, it must shrink by 10 per cent to live within its remaining outstanding sub debt. This system is stable because any bank can contract by 10 per cent within a year by letting loans run off and/or by selling other assets. It is highly desirable that contraction be managed by the bank itself and not by regulators.
Full discussion can be found t the FT
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Source:
A market solution to secure banks’ future
William Poole
FT, May 20 2009 23:07
http://www.ft.com/cms/s/0/7e18b390-4587-11de-b6c8-00144feabdc0.html
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May 21st, 2009 at 1:32 pm
Would be difficult to implement for small banks. Small issue sizes in the debt market are tough to place, and rolling over 1% each year makes the sizes smaller still. The sub debt would have to be at the operating bank subsidiaries, which are smaller than the holding companies.
I like the idea, though. Maybe a market would develop for small bank sub debt… maybe even funds specializing in it. The yields could be significant, and even protected to some degree, given the need to roll it over to stay operating.
That said, loss incidence might be infrequent, but loss severity would be high. That’s true of losses on unsecured financial debt generally, but it would be worse with sub debt.
As Barry says, this idea is not new, but it is worth a try. The financial analysis of banks by regulators who have little economic incentive to be right, and hampered by politics has not worked well. It would be replaced by profit-seeking analysts who do have an incentive in the health of the bank in question.
May 21st, 2009 at 4:43 pm
David, the small banks are not really the problem, since their failures could normally be handled by FDIC. Even an abnormally large number of small failures can be absorbed. It’s the big monsters that need extra controls.
May 22nd, 2009 at 1:20 am
David,
w/this: “Small issue sizes in the debt market are tough to place…”
those issues could be sopped up by the Bank’s depositors, in a hurry, in lieu of, or in addition to, CDs, for starters..
the local Corporate customers, local gov’t/school board Pension Plans, even a “March of Dimes” could cover the Nut..
the Banks “Cash back” CC customers could receive them in lieu of FedRes ‘Notes’, if they chose..
the possibilities are, literally, endless.
now, though, Regulation from on High, from far away, is the only Commodity that is not Scarce..
May 22nd, 2009 at 1:24 pm
I agree, both of you. But Poole’s article starts out with “Too big to fail,” and continues with “every bank.” He is proposing it for all, not just the big guys.