Bad Banks Bring Trust Back
The quarterly earnings announced by Goldman Sachs (more than $1.8 billion) and JP Morgan Chase ($2.1 billion) give hope to investors, who have been disappointed by the dismal financial performance of global banks over the past few months. These early signs of recovery do not erase negative signals coming from UBS (losses exceeding €2 billion) and especially Citigroup, whose struggles point to lingering problems affecting the solidity of the US bank.
On the whole, it seems that the financial crisis has not yet been fully absorbed, particularly in the US and UK where it started. Over the last months, governments and central banks have mounted an unprecedented coordinated effort mostly focusing on the recapitalization of private financial institutions.
In a few cases, this was equivalent to an outright nationalization of banks, as in the cases of Fortis in Belgium and Royal Bank of Scotland in the UK. The underlying philosophy of state interventions is fairly simple. Given a certain amount of risky assets held by banks, the banks' own capital is deemed insufficient. Thus deleverage must follow. No wonder that CEOs of major international banks, including Italian ones, stress their attempts at strengthening their total capital ratios and core Tier I ratios to bring them to acceptable levels for investors. The strategy of deleveraging must find public and political support if the market gives the cold shoulder to attempts at recapitalizing banks.
The issue was already put forward by former US Treasury Secretary Hank Paulson: why is the market not willing to supply new funds to banks, forcing the public hand to take over that role? The answer is that no rational investor is ready to put his/her money in a financial asset for which he cannot estimate the associated level of risk. The "bad bank" solution means creating a vehicle, capitalized by private investors and governments, into which all the problematic assets banks hold can flow. It acts at the root of the problem. While deleveraging can change the structure of liabilities a bank has, a bad bank acts on the riskiness of the assets, liberating solid assets from the malign influence of toxic ones. It's an elementary principle of finance to separate two classes of assets having very different characteristics; investors are likely to have a more positive view of both.
This way, more risk-prone investors might decide to invest in the bad bank's risky assets and consequently demand a higher return, while risk-averse investors can continue to invest in the cleaned-up bank without extracting excessively high returns on the capital invested. To be sure, the bad bank model is not so easy to implement. There is the sensitive problem of deciding at which price the problematic assets should be sold. But this is a technical, rather than philosophical, issue which should not overshadow the positive evaluation of a policy tool currently sidelined by governments, but which could solve the critical problem of the lack of trust still clouding financial markets in their dealings with banks and other financial intermediaries.