Public assistance must protect the taxpayer


Mr Paulson has taken the bad bank for US taxpayers and left shareholders with the good bank. Mr Darling should do the opposite

Government intervention in business usually has unintended consequences. The results of regulation are often disappointing but the scope and scale of regulation nevertheless expand. Regulation works best when it is narrowly focused on defined objectives. We now regulate airline safety, not the airline business, since prudential supervision of the industry created an elaborate panoply of controls that came to serve only the interests of established operators, and often not even them.

When governments intervene in the banking crisis, their objectives should be equally narrowly focused and on what matters to the public, not what matters to the banks. We have no reason to care whether the interbank market is functioning well, nor should it be a policy objective to revive the issue of mortgage-backed securities. The interbank market was many times larger than needed to secure its economic function, and the residential mortgage-backed securities market should probably never have come into existence: banks will be sounder and their lending decisions wiser if the loans they underwrite are on their own balance sheets.

However it feels on Wall Street and Canary Wharf, this is not the worst economic crisis since the Great Depression. Today’s problems are not only created by financial markets but largely confined to them. Compared with the wreckage of Europe’s physical infrastructure in the 1940s, or the threats to living standards and social order from oil shortages and accelerating inflation in the 1970s, these perturbations are minor. The greatest threat to the non-financial sector is the effect on business and consumer confidence that comes from apocalyptic headlines.

The travails of the banking system matter less to the public than to bankers, but they do matter. The payments system is an essential utility; companies and individuals must be able to receive cash and pay invoices. The most feared event is a recurrence of March 1933 with customers unable to use their cheque books and locked out of their banks. But the central banks of the world have now flooded the system with liquidity and if your bank cannot pay your bills, it is because it is short of assets, not because it is short of cash.

The next public objective is to reassure those who are rightly uninterested in studying the impenetrable accounts of banks to make sure their savings are safe. The deposit protection measures that are in place – implicit or explicit – are more or less enough to do this. Despite panicky headlines, the volume of retail deposits that have been withdrawn from big banks are a small percentage of the total.

The largest problem for the real economy, beyond the crisis of confidence, is the difficulty, though not impossibility, that good borrowers find in obtaining credit. This is not because banks do not have sufficient cash. It is partly because they are short of capital. But even better-capitalised banks are reluctant lenders. The main cause of the credit shortage is an overdue fit of prudence.

Another lesson from experience of government intervention is that temporary public assistance to get companies over a bad patch is rarely either temporary or effective. When government funding comes in, other funders move out. Things are almost always worse than management admits, or perhaps knows. When the share price or the credit default swap rate has told a different story from the one senior executives tell, the market has generally been a more reliable predictor than the trading statement.

Even large-scale recapitalisation of banks will not ease the pressure on lending much, but it will do so a bit and is certainly the measure most likely to have an effect. All other measures take us down a road whose destination is not clear but certainly distant. Since there are fine ongoing retail and corporate businesses in the banking sector, the idea of separating the good banks from the bad banks makes sense. The scale of necessary recapitalisation may imply a public contribution. But Mr Paulson got it the wrong way round. If taxpayers are called on for cash, they should enjoy the major equity stake in the good bank and leave the value of bad banks behind with the shareholders.

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