Dollars and Jens
Thursday, October 02, 2008
net worth certificates
A different proposal for government assistance to banks, one that was used twenty years ago:
The FDIC purchased net worth certificates (subordinated debentures, a commonly used form of capital in banks) in troubled banks that the agency determined could be viable if they were given more time. Banks entering the program had to agree to strict supervision from the FDIC, including oversight of compensation of top executives and removal of poor management.

The FDIC paid for the net worth certificates by issuing FDIC senior notes to the banks; there was no cash outlay. The interest rate on the net worth certificates and the FDIC notes was identical, so there was no subsidy.
Insofar as the FDIC doesn't perfectly know who's going to remain solvent and who isn't, this still represents a subsidy in an expected value sense: the FDIC is essentially providing a partial guarantee to creditors in exchange solely for some additional oversight. Still, if John Hempton is right, and the problem is ultimately one of creditor faith in the reasonable safety of banks and willingness to lend to them — and I'm increasingly buying that — then this seems like a better way to go about it than anything else I've seen, at least provided the FDIC can do a decent job of discerning who's solvent and maintaining the political will to let insolvent banks go.

Recapitalization of banks is important for the real economy, but recapitalization of banks that are insolvent is not a long-term good use of resources, and once the financial markets are confident in solvent banks, they will be able to recapitalize themselves through those markets. It doesn't make sense to me for the government to do anything to try to promote recapitalization except for helping the markets figure out what's worth recapitalizing.

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