Beware the Zombie Banks!

Zombie banks seem to be killing our economy, just as financier George Soros predicted. Zombie banks do not lend money because they are worried about remaining solvent and staying in business (so they may continue to pay outrageous bonuses and golden parachute payments to their inept CEOs and senior officers). Zombie banks are widely viewed as the root cause of the now 20 year old Japanese contraction. Rather than lending money on reasonable terms zombie banks use government subsidies to soak borrowers and drive out competition. Further, zombie banks squeeze out profits from healthy competitors through the advantages of government subsidies and thereby cause industry-wide stagnation and job losses.

According to the FDIC, bank lending contracted by $116 billion in the fourth quarter of 2008 and $138.5 billion in the first quarter of 2009, as indicated in the chart above. The Wall Street Journal reports that lending fell an additional 2.8% in the second quarter of this year. This coincides with a newly revised GDP numbers that track the contraction in lending; for example, GDP contracted at a rate of 5.4% in the fourth quarter of 2008 and 6.4% in the first quarter of 2008. In the just completed second quarter, the contraction in GDP seems to be slowing, based largely on increased government expenditures now amounting to 20% of the economy.

This is some cause for optimism, but the economic problems posed by zombie banks are not likely to be resolved any time soon. The IMF now projects total toxic assets in the world financial system will reach $4 trillion, and banks have recognized less than half of these losses. Moreover, securitized credit in the US has fallen over 60%. Much of the recent optimism in the financial sector is also the result of changes in accounting rules that allow banks more discretion in valuing assets that previously had to be marked-to-market. Earlier this spring Paul Krugman suggested that we should prepare for a lost decade of zombie banking. Since then he thinks that the risks of a zombie economy have increased; I argue that the greater estimated losses and the use of accounting machinations to conceal deep financial wounds means that a zombie economy is a near certainty. The net result is gross injustice and perverse incentives that are economically corrosive.

I have previously suggested on this blog that a government regulator should have the power to order prudential divestitures to assure that no bank ever becomes too-big-to-fail again. Given the enormous costs of bail-outs generally, and financial bailouts in particular, however, I now suggest that the power to bailout financial firms rest with a separate, non-banking regulator. The non-banking regulator should have the power to organize government assistance for any firm (financial or not) the failure of which would present a severe economic disruption.

Even then the regulator should be required to find that rescuing the firm is highly likely to result in profits to the taxpayers and will result in a viable firm over the long run with substantial certainty. This regulator should be depoliticized, like the Fed, but have no significant ties to any one industry, financial or otherwise. It should be self-funded, through a tax on any economically significant public firm–like a users’ fee. Government assistance should come with severe restrictions with regard to compensation (bonuses and golden parachute arrangements should be dischargable by the bailout agency), and any individual who engages in reckless conduct leading to substantial government expenditures should be subject to fines (commensurate with the cost to the public fisc and the degree of their recklessness) and disbarment from serving as an officer or director of a publicly traded firm–meted out in an administrative proceeding. Criminal sanctions should be reserved for knowing misconduct leading to government assistance. The PSLRA should also be amended so that it does not apply to officers and directors of bailed-out firms. That way, securities fraudfeasors (currently protected by the PSLRA) would at least think twice before defrauding shareholders of an economically significant firm. Senior management of rescued firms should be terminated, unless their service is vital to the success of the firm.

Because creditors could not count on government bailouts under this regime they would not carelessly supply cheap capital to any large firm. The user fee would therefore likely result in a higher cost of capital for firms flirting with too-big-to-fail status. CEOs and directors would find government bailouts distinctively unpleasant. Incentives toward prudence would be restored. This proposal therefore would greatly contract the problems associated with too-big-to-fail.

The problem is not that the law cannot remedy the too-big-to-fail problem; the problem is that the financial sector may have too-much-political-power-to-reform.