How to Manage the Banks

The Treasury plans to invest up to $250 billion in individual banks and has already allotted half that amount to nine leading banks. For now, the key questions are: Will the plan work? And what consequences will it have for our financial system and our economy? Several issues bear examination.

First, is this enough money? Citigroup, for example, is getting $25 billion. As of June 30, it had $2.1 trillion in assets and just $136 billion in capital; the new capital is only 1.2 percent of its total assets. If the problem is that falling asset prices could put banks' solvency at risk, the Treasury might have to commit more money.

In truth, no one knows how much funding is needed. The reduction in lending (known as "deleveraging") underway throughout the world may lead to a sharp recession. Some European nations, which have large financial sectors and substantially greater leverage than in the United States, pose risks to all nations. The United States needs to be prepared to quickly shore up capital among banks, and potentially major insurance companies and other financial firms, if it appears the recession is deepening.

The Treasury should abandon plans to buy troubled assets (this can be handled by Fannie Mae and Freddie Mac, as necessary) and keep the full $700 billion from the Troubled Asset Relief Program for financial-sector recapitalization if needed. Congress should amend TARP rules so the full $700 billion is available at the discretion of the president.

Second, which banks should get new capital? Treasury official Neel Kashkari said Monday that equity injections would go only to "healthy banks," raising the possibility that the Treasury would invest in a small set of protected banks and allow them to acquire the assets of banks that fail. Today's term sheet, however, seems to open participation to any "qualifying financial institution." We agree that the Treasury should invest in any bank that needs capital, an approach that is arguably fairer and will ultimately ensure a more competitive system. Some banks that receive federal funds may ultimately fail. But it is essential that the Treasury not favor a handful of large banks.

Third, how good an investment is this for taxpayers? The government is buying preferred shares, which carry a 5 percent dividend and do not dilute common shares, along with a small amount of warrants. In a narrow sense, the deal terms are much worse than the terms Warren Buffett negotiated when he invested in Goldman Sachs this month. (He received a 10 percent dividend and warrants to buy additional common shares at well below market prices.) But the Treasury has taken a sensible broader view-in leaving more for banks' other shareholders and creditors, it has taken a major step toward restoring confidence in the global financial system.

Fourth, what role should the government play in managing the banks? A government recapitalization requires balancing the interests of the banks (or their shareholders), the taxpayer (as an investor), and the public good. The Treasury has deployed a relatively small amount of taxpayer money to a few banks, at least in the first phase, in a form that minimizes the impact on current shareholders and gives the government little influence on bank operations, since the new shares will have no voting rights. The British plan, by contrast, devoted more taxpayer money to gain a controlling interest in one major bank (RBS) and more than 40 percent of a newly merged bank (the combined Lloyds TSB and HBOS), with the right to appoint directors to both boards. It also imposed new controls over the banks, which risks politicizing operations: As Britain enters what could be a major recession, there will be large pressures on partly nationalized banks to channel credit according to government's will. The United States, in contrast, is putting the full credibility of its balance sheet behind banks but giving them free rein to move on. Both plans have pitfalls. We taxpayers need to trust that the authorities are prepared to regulate the "ordained banks" with a much stronger hand than they have in the past.

Congress should create a consolidated and powerful regulator that can stand up to the banks. All regulatory rules have to be rethought, given that any sizable financial institution is now seen as too interconnected to be allowed to fail.

On balance, this US (and European) policy is likely to restore immediate confidence in banks. This is a remarkable shift from the rough treatment of shareholders and creditors at Lehman Brothers and AIG, which helped create the panic of the past few weeks. These new policies correct those errors. Now, let's hope the Treasury is done being fickle.

Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT. He is a cofounder of the blog Baseline Scenario (http://baselinescenario.com).