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Financial Crises and Bank Capital.

Introduction

The U.S. government's decision to allow Lehman Brothers to close on September 15, 2008 was the costliest mistake in American financial history, measured both by the sharp decline in U.S. GDP, relative to the projected decline in August 2008, and by the surge in the indebtedness of the U.S. Treasury. The U.S. government sought a buyer for Lehman, but was unwilling to commit taxpayer funds to facilitate the purchase by Barclays or by a consortium of U.S. banks, even though the Fed had made a massive commitment to induce JPMorgan Chase to buy Bear Stearns. The Paulson-Bernanke claim that the U.S. government did not have the authority to provide taxpayer funds so that Lehman could remain open was smoke. The Bush Administration made a political decision that taxpayer money should not be used to enable Lehman to remain open. Richard Fuld, the head of Lehman, may have been the least popular banker on Wall Street and was not Paulson's best friend. The Bush Administration may have concluded that saving Lehman would lead to charges of nepotism. George Walker, President Bush's first cousin, ran Lehman's asset management decision. Richard Paulson the brother of the U.S. Secretary of the Treasury, sold mortgage-backed securities for Lehman in Chicago. One analyst concluded that Lehman was solvent and could have remained open without any permanent cost to the taxpayers.

Lehman's closing led to a freeze in the international credit market and a surge in the demand for money. Spending declined sharply. Paulson-Bernanke greatly underestimated the costs of Lehman's bankruptcy, which suggests that they did not understand the cause of the surge in property prices that had begun in 2003. The credit crunch revealed that the Fed and the Treasury had done little contingency planning to cope with the financial distress that would follow from the decline in property prices.

The 2008 U.S. financial meltdown was a systemic crisis. Between 2003 and 2006, the market value of U.S. residential real estate increased substantially. Much of the increase was in 16 states that accounted for the majority of U.S. gross domestic product (GDP), so the percentage increase in prices in many local markets was much greater than 100%.

This paper reviews the taxonomy of bank failure wherein few small banks fail because of idiosyncratic firm-specific factors. In contrast, when a large number of banks fail at the same time, including some large ones that previously had been considered well-managed, the cause is a systemic shock that leads to a large change in the relationship between the prices of two large asset classes.

An explanation is provided for the surge in U.S. real estate prices and those in many other industrial countries between 2003 and 2006. Including Britain, Ireland and Iceland, six such countries also had banking crises. The paper asserts that the regulatory initiatives, adopted to forestall a repetition of the 2008 crisis, ignored that significance of cross-border investment variability relative to the prices of different asset classes and are likely to be irrelevant in forestalling a crisis.

This paper proposes that a new government agency, modeled on the Reconstruction Finance Corporation (RFC), be established to de-politicize the re-capitalization of failing banks and minimize the tendency to consolidate banks when one fails. The new government agency, RFC II, would receive common stock and preferred stock that would be convertible into common stock in exchange for a capital infusion. Hence the ownership interests of existing shareholders would be diluted and top managers would be scalped. Once the economic environment was stabilized, the RFC II would sell its shares.

Why Banks Fail

One reason banks fail is idiosyncratic or firm-specific and may reflect self-dealing by top managers or the deterioration of the local neighborhood. The monetary system is stable. The major reason that a large number of banks fail at the same time is systemic shock that leads to a sharp change in the price relationship between two assets classes such as stocks and bonds, bonds and real estate, domestic securities and foreign securities, and short- and long-term securities. A systemic shock often occurs after an extended episode of investor reliance on money from new loans for interest payments on their outstanding indebtedness.

Walter Bagehot, in his classic Lombard Street (1873), advised that a central bank should provide unlimited credit to an illiquid but solvent bank. Otherwise, the bank would sell assets to enhance liquidity and the induced decline in asset prices might cause some otherwise solvent banks to become insolvent. Bagehot also wrote that a central bank should not assist an insolvent bank. This distinction is logically fallacious because the boundary between solvency and insolvency changes as asset prices fall. A bank often becomes illiquid because its peers are not 100% confident that it is solvent and will remain so one and three months from now. If a bank is insolvent, the courts will require that its assets be sold to satisfy creditors, the prices of the assets will decline, and the solvency of other institutions will be impaired.

Central banks were established to provide unlimited liquidity. Bagehot advised that the loans from the central bank be set at a penalty rate. Deposit insurance was adopted first at the state level and then at the national level to reduce the likelihood that depositors would "run for their money."

The U.S. experienced four systemic shocks after the Federal Reserve was established in 1914. Each shock was associated with a sharp change in the price relationship between two classes of assets. The first episode was during 1920 when agricultural prices declined sharply. Farm land values increased dramatically in the previous several years as food prices soared.

The second was the Great Depression of the early 1930s, which followed the sequential devaluation of many currencies that began in the late 1920s as countries stopped pegging their currencies to gold. The decline in export earnings in these countries because of the Smoot Hawley Tariff of 1930 (U.S. House of Representatives Office of the Law Revision Counsel 1930) led countries to reduce the prices of their currencies, which contributed to downward pressure on the prices of agricultural goods. These declines in the prices of currencies led some investors to buy gold, which caused banks to become more cautious lenders. The systemic crisis in the early 1980s was triggered by a shift to an extraordinarily contractive monetary policy at the end of 1979. This shift led to a sharp increase in interest rates on short-term securities relative to interest rates on long-term securities. The failure of more 500 banks in 2008 and 2009 and the decimation of the U.S. investment banking industry followed a sharp decline in real estate prices after four years of sharp price increases.

The U.S. government took a benign-neglect approach to the 1920 crisis with the Fed remaining on the sidelines. The U.S. was still largely an agricultural country. Commodity prices declined by 40% after rapid increases in the previous three years. Hundreds of banks closed and there was a brief sharp recession.

The RFC was established in 1932 to provide capital to banks that experienced large loan losses. Banks failed in the previous two years as a result of the decline in the price level and the increase in real interest rates. U.S. banks were squeezed because of the decline in U.S. prices of traded goods in response to the drop in foreign currency prices and the increase in investor demand for gold. As U.S. banks failed, homeowners with mortgage indebtedness discovered they could not refinance maturing loans (then primarily five-year terms) and they became distressed sellers of real estate. President Roosevelt nationalized American holdings of gold soon after he took office, which reduced banks' concerns about liquidity.

Systemic shock in the early 1980s followed the adoption of sharply contractive monetary policy in late October 1979. The Fed's policy had been feckless in the previous several years and slighted investor concerns that the U.S. inflation rate would accelerate. U.S. short-term interest rates surged relative to long-term rates. The interest rate yield curve became negative and interest payments on the short-term liabilities of thrift institutions climbed above interest income on long-term mortgages. The capital of these firms was being depleted. The concern was whether short-term interest rates would decline sufficient to reduce the bleeding before the firms failed. The U.S. government eased some regulations to facilitate firms "earning their way out of their holes", which led to financial shenanigans as investors gamed the deposit insurance arrangement.

The failure of more than 500 banks since 2007 reflects the sharp decline in home prices that began at the end of 2006, which led to more than ten million foreclosures or nearly 10 % of the housing stock. The Greenspan Fed adopted an expansive monetary policy in 2002, which contributed to the increase in real estate prices and the consumption spending boom financed with mortgage-equity withdrawals. Prices peaked toward the end of 2006. Policies adopted to dampen the impact of declining property prices included the establishment of Maiden Lane I, to facilitate JPMorgan Chase's purchase of Bear Stearns, and the establishment of Maiden Lane II, to enable American International Group (AIG) to remain in business (Board of Governors of the Federal Reserve System 2008a, 2008b). In October 2008, the U.S. Congress approved the request for $700 billion (the Troubled Assets Relief Program (TARP)) to enhance the capital of banks (U.S. Department of the Treasury 2008).

Once property prices start to decline, banks become more cautious lenders. Some borrowers will not able to refinance maturing debt and become distressed sellers of real estate, which could cause the price decline to accelerate. Without government intervention, prices could decline below long-run equilibrium values. For example, home prices in Florida declined below reproduction costs, which suggests (incorrectly) that the land had negative value.

The imbalances that preceded the systemic crises of the early 1980s resulted from the feckless monetary policy of the late 1970s. The imbalances that preceded the 2008 crisis followed the sharp increase in investor demand for U.S. dollar securities and the expansive monetary policy that the Greenspan Fed adopted in 2002 to stimulate the economy after stock prices had started to decline sharply.

Global Surge in Real Estate Prices

The U.S. banking crisis of 2008 was a country-specific manifestation of a global event. Four other countries (Great Britain, Iceland, Ireland, and Spain) had crises at the same time. Greece and Portugal had sovereign debt crises about 15 months later. Iceland's banking crisis was triggered by its currency crisis when banks defaulted on their foreign loans. For the previous five years, banks had relied on money from new loans to cover interest payments on their outstanding indebtedness denominated in foreign currencies. The crises in these countries followed booms that were associated with increases in their external indebtedness. Nearly 20 countries experienced real estate booms. The features of these 2008 crises were similar to the currency and banking crises in Thailand, Indonesia and other countries in Asia in 1997 and to the Mexican crisis during its presidential transition at the end of 1994.

The likelihood that the 2008-2010 crises in seven countries were independent national events is trivially small. Moreover, the preludes to the sovereign debt crises in Greece and Portugal were similar to those in countries that had banking crises, with the major difference being the borrower's identity.

Every country that experienced a banking crisis since 1980 previously had a boom. Not every boom was followed by a crisis, but every crisis was preceded by a boom induced in response to the increase in its capital account surplus. The boom in Japan was associated with a decline in its capital account deficit. (The first difference of the change in the Japanese capital account deficit was the same as the first differences in the changes in the capital account surpluses of countries such as the U.S. and Great Britain). The capital account surplus in these countries could not increase unless there was a contemporary increase in current account deficit. The increase in capital account surpluses led to consumption booms as prices of securities, real estate and, hence, household wealth moved up.

The external shock that led to the booms that preceded the 2008 global crisis was a sharp increase in the demand for international reserve assets, partly from the oil-exporting countries (OEC) including Norway, Saudi Arabia and the United Arab Emirates, and partly from China. Soon after 2002, these countries experienced increases in their export earnings about the time that China became a member of the World Trade Organization (WTO). These countries used part of the increase in their export earnings to buy off-the-shelf securities available in the U.S., Great Britain and other industrial countries, which meant that the capital account surpluses of the U.S. and these other countries increased.

China, the OEC, the U.S. and other industrial countries were involved in a complex tango. The countries in the former group could achieve increases in their current account surpluses only if there were adjustments in the major industrial countries that would lead to counterpart increases in their current account deficits. Invisible hands were at work to motivate spending increases in the industrial countries. The principal factor was the surge in prices of real estate and stocks that led to greater consumption spending. Increases in the currency prices of these countries were associated with increases in their capital account surpluses.

Iceland's capital account surplus increased from 1 % of its GDP in 2003 to a peak of 18% in 2008 (Central Bank of Iceland 2018; Statistics Iceland 2018). Iceland had a massive boom, stock prices increased nearly tenfold and real estate prices doubled. The increase in asset prices was a response to the surge in the supply of credit from two sources. One was the sharp increase in cross-border investment inflows and the other was the dramatic increase in the domestic loans of the three Icelandic banks. (An increase in the growth of domestic credit, by itself, would have led to the increase in asset prices and total spending. The price of the Icelandic krona would have declined because of the increase in spending on foreign goods). The autonomous increase in investor demand for Icelandic securities led to higher prices for Icelandic stocks that enabled the banks to rapidly increase domestic loans. The capital of the three Icelandic banks increased significantly each year. Some bank borrowers used the money to buy goods. Others bought real estate and stocks.

The Icelandic banks took the initiative to sell more of the IOUs in foreign centers soon after they were privatized. They brought some of the foreign funds to Iceland which they converted to krona so they could increase their krona loans. They also lent some of the foreign funds to Icelandic households and business firms, who brought some of these funds to Iceland and also converted them to krona. Iceland could experience an autonomous increase in its capital account surplus only if there was a counterpart induced increase in its current account deficit. The principal factor contributing to this surge in consumption spending was the dramatic increase in household wealth. The secondary factor was the increase in the price of the Icelandic krona.

The capital of the Icelandic banks increased as stock prices increased, which enabled them to buy more domestic loans. Their assets and liabilities also increased substantially. (Note, there is no special stash of securities called bank capital.)

The necessary condition for the banking crisis in Iceland was that the external liabilities of the Icelandic banks had increased each year for six consecutive years at a rate more rapid than the increase in its GDP. It was inevitable that at some stage, lenders would become more cautious about buying Icelandic "IOUs", and the price of Icelandic krona would decline. The sufficient condition was that the ratio of Iceland's gross external liabilities to its GDP was substantially larger than the increase in its net international indebtedness. The difference was the increase in the net foreign assets of Icelandic firms and investors. When foreign demand for Icelandic "IOUs" slowed, the price of the Icelandic krona declined substantially, since Iceland was no longer be able to finance a trade deficit. Denominated in a foreign currency, the krona equivalent of indebtedness of the Icelandic households and business firms increased. Some Icelandic borrowers with indebtedness denominated in foreign currency inevitably sold domestic stocks and real estate to obtain funds for debt service payments and the prices of these assets declined. Other borrowers defaulted. As the price of Icelandic stocks fell, Icelandic bank capital declined and banks shrunk their assets, selling stocks and not renewing some maturing loans. The Icelandic banks reduced loans to Icelandic borrowers, some of whom became distressed sellers of assets while others defaulted.

The U.S. capital account surplus surged in the early years of each of the four decades beginning in the 1980s. This surplus declined in the last several years of the first three decades. Generally, the increase in the U.S. capital account surplus was associated with an increase in the price of the U.S. dollar, except during the 2000s.

The ratio of the U.S. capital account surplus to U.S. GDP increased by approximately three percentage points from 2002 to 2006 as sovereign wealth funds and foreign central banks bought U.S. securities. The massive increase in U.S. real estate prices was induced by the increase in the U.S. capital account surplus. This ensured that there was an induced increase in the U.S. current account deficit that more or less continually corresponded to the autonomous increase in the U.S. capital account surplus.

Japan experienced the "mother of all asset bubbles" in the second half of the 1980s. Property and real estate prices increased by roughly threefold. The background for the Japanese experience differed from those of most other countries, since Japan had a large, but declining, capital account deficit in the second half of the 1980s. During the first half of the decade, there was a surge in Japanese purchases of U.S. dollar securities. By 1985, the U.S. dollar had become overvalued. The incentives for Japanese investors to buy U.S. dollar securities had greatly diminished. Instead, Americans began buying Japanese securities, motivated both by the increase in the price of the Japanese yen and by the increase in the price of Japanese stocks. Japan had to adjust to a decline in its capital account deficit, which could have occurred only if there was a counterpart decline in its current account surplus. The principal factor that contributed to the reduction in Japan's current account surplus was the sharp increase in the prices of real estate and stocks which led to a surge in consumption spending.

The transfer problem was at work in Iceland, the U.S., Japan, and in each country that experienced an autonomous increase in capital account surplus. When a country's currency is not anchored to a parity, the country cannot experience an increase in capital account surplus unless there is a comparable increase in the country's current account deficit. Every country that had a banking crisis previously had an asset price boom. Every one of these countries, except Japan, experienced an increase in capital account surplus, which occurred only if there was a corresponding increase in the country's current account deficit. An alternative perspective is that asset prices rose by the amount necessary to ensure that consumption spending increased and that demand for imports rose to ensure that the country's payments increased to match the increase in receipts.

Irrelevance of Dodd Frank

It is fascinating that, despite the almost 150 years that have elapsed since the publication of Lombard Street (Bagehot 1873), financial regulators in many countries still do not understand the fallacy of composition. Home mortgage loans are collateralized by real property in the U.S., Japan and numerous other countries. If real estate prices increase, banks can increase the amounts they lend against higher market value. Bank profits will increase as a result of the increase in transaction volume. (This cycle of higher real estate prices and larger bank profits mirrors Fisher's debt deflation cycle (1933)). The regulators have not asked whether the market value of the real property was consistent with long-term equilibrium based on household incomes and the rental rate of return.

As Maureen Dowd (2018) suggested in her New York Times opinion column, some bankers profited greatly from the monetary ease of the 2002-2005 period, in part from the fees associated with the production and trading of asset-backed securities and mortgage-backed securities. The volume of these securities surged because of the massive increase in the supply of credit, partly from investment inflows and partly from domestic credit creation.

The dominant view is that the 2008 crisis resulted from the shortcomings of regulation. First, the perimeter of regulation was considered to be too limited, implying that too many lenders were not regulated, facilitating a "shadow banking system". Banks had specialized investment "vehicles" that could undertake transactions that the banks themselves could not undertake. Second, the scope of regulation was considered too limited because derivatives were not regulated. A third criticism was that the regulators were "asleep at the switch". Career regulators want a quiet life, like firemen in the desert.

A competing view implicit in the previous section of this paper is that regulation is irrelevant when there is a surge in the credit supply. The U.S. had to adjust to an increase in investor demand for U.S. securities. The U.S. capital account surplus could have increased only if there were a comparable increase in current account deficits. The primary factor that led to the increases in current account deficits was the increase in prices of securities and household wealth. During the U.S. consumption boom, the inflow of foreign saving displaced domestic saving.

The Wall Street Reform and Consumer Protection Act of 2010, more popularly Dodd-Frank (DF), is the most comprehensive attempt at financial regulation to avoid a crisis like the one in 2008 (U.S. House of Representatives Office of the Law Revision Counsel 2010). The theoretical cause of the crisis can be inferred from the measures adopted to reduce the likelihood of another similar meltdown. The inference from the increase in capital requirements and limitations is that each bank failed because of idiosyncratic factors. The implicit view is that the cause of the 2008 crisis was some sort of "financial flu" that hit more than 500 banks with the same symptoms at about the same time. DF ignores the interdependence of bank failures. DF requires that banks be subjected to stress tests. However, the practice is that Bank of America, Citibank, and Wells Fargo are subject to the stress test on successive days of the week (Monday, Tuesday, and Wednesday). The regulators appear not to have asked whether these three banks could pass the stress test on the same day.

The U.S. has no established procedures to deal with a systemic shock that leads to a large decline in capital for all banks as a group or even for a large bank like Continental Illinois Bank. When this bank was failing in 1984, the Federal Reserve ensured that the bank would continue to function. No effort was made to recapitalize the bank in a formal way, but the support of the Fed was an implicit capital injection for a brief period.

DF does nothing to insulate the U.S. economy from an increase in investor demand for U.S. dollar securities and the temporary increase in U.S. asset prices that occurs as an integral part of the adjustment program. Moreover, DF does not recognize the costs of financial regulation. Regulations incur costs and someone pays. An increase in the bank capital requirement increases the costs of financial intermediation and leads to the expansion of non-regulated financial firms.

DF does not recognize that the U.S. banking crisis of 2008 resulted from variability in the U.S. capital account surplus. The autonomous increase in this surplus induced a massive increase in the price of U.S. real estate as an integral part of the adjustment process to ensure that the U.S. current account deficit increased as the U.S. capital account surplus increased. If this legislation had been adopted in 2000 and the flow of investor funds to the U.S. taken as a given, U.S. banks would have supplied less credit and some non-bank lenders would have supplied more credit. When investor demand for U.S. dollar securities slackened, U.S. real estate prices fell. DF would not have forestalled the surge in U.S. real estate prices because of the sharp increase in investor demand for U.S. securities.

The Reconstruction Finance Corporation

U.S. government regulations developed to prevent the failure of individual banks are more extensive than the sum of all regulations applied to all other industries combined. One motive is consumer protection. Another is economic stability since bank failure can be devastating for a small community. A third motive is that failure of a number of banks in a systemic crisis disrupts the national economy and leads to a much larger decline in GDP than in a traditional recession.

Each of the four waves of banking crises since the early 1920s has been in response to a systemic shock. Hundreds of U.S. banks failed in the early 1930s because of downward pressure on U.S. tradeable goods prices that followed from declines in foreign currency prices and the rush for gold by American households. More than 1000 banks and thrift institutions failed in the early 1980s in response to the surge in interest rates that resulted from the sharply contractive monetary policy that the Federal Reserve adopted in October 1979 to crush anticipation of accelerating inflation. More than 500 U.S. banks failed after 2008 following the property price implosion, which doubled at the national level in the four previous years. These dramatic increases could not have occurred without a superabundance of credit.

The irony is that banks were blamed for the 2008 crisis, even though they were victims. Some bankers were villains, buying mortgage loans from those who could not afford the monthly payments. The Greenspan Fed did not comprehend the effects of the increase in the U.S. capital account surplus on the prices of U.S. real estate and stocks.

The traditional U.S. approach has been to merge failing banks with healthier banks, a marriage that is often blessed by removing poorly performing assets. The ratio of an acquiring bank's capital to its deposits inevitably declines. This approach leads to consolidation of banking firms. There is no systematic approach to re-capitalizing failing or failed banks, so the process inevitably involves extensive political, rather than administrative, decisions. Failure to provide government capital so that Lehman Brothers could remain open was the costliest mistake by a U.S. administration in the last 200 years. The cliches "too big to fail" and "bailing out the bankers" dominated decisions about government investments that would assist in economic stabilization during the systemic crisis.

The U.S. Congress should establish a Reconstruction Finance Corporation II (RFC II) to provide funds to recapitalize failing and insolvent banks. The RFC was established in 1932 to provide capital to failing banks and firms in other industries (Jones and Angly 1951). RFC II would buy newly-issued common shares in any bank deemed to have too little capital, thus the ownership interest of the existing shareholders would be diluted. If the capital requirement for each bank is 5% of assets and loan losses reduce capital to 4%, RFCII would write a check to the bank for the dollar amount required to elevate capital to the 5% minimum. RFC II would receive newly issued common shares so that it would own 20% of the bank. If instead capital declined to 3%, RFC II would receive the equivalent number of newly issued shares so it would become the owner of 40% of the common shares. If the decline in capital was larger, the RFC II would write a check so that it would own 50% of the common shares. The bondholders would be required to participate in a debt-for-equity swap.

Once RFC II had acquired common shares in a bank, it would become the controlling shareholder. The senior two or three officers would be removed and the board of directors would resign. These RFC II banks would be managed as private enterprises on a caretaker basis. The thrust would be to prepare the banks to be privatized within three or four years.

The objective of the proposal is to stabilize the U.S. banking system in response to the impact of the variability in investor demand for U.S. dollar securities on household wealth. An increase in this demand leads to a boom, while a decrease leads to a bust. The current arrangement requires that bank assets adjust to the level of bank capital, which often has been declining. Instead, the proposal provides a low-cost way to adjust capital to the value of bank assets.

One advantage of this proposal is that it would sharply reduce the consolidation of banks that now occurs when the Federal Deposit Insurance Corporation (FDIC) induces a strong bank to buy a failing bank. A second advantage of the proposal is that RFC II would be profitable, at least this is the inference from TARP, Maiden Lane I and Maiden Lane II. RFC II would be a classic vulture investor. It would profit because it would acquire failing banks when their values were greatly depressed because of cyclical crash.

A third advantage of the proposal is that it would depoliticize the extension of government support for failing banks, as there would be well-publicized procedures for providing government capital. The cliche about "bailing out banks" might be trashed. Banks would be saved and top bankers would be furloughed. A fourth advantage of the proposal is that the effectiveness of monetary policy would be enhanced. The Federal Reserve would no longer be concerned about the impact of increases in interest rates on financial stability.

A fifth advantage of the proposal is that it would reduce the "tax" on banks from high capital requirements. These requirements have no advantage. They are irrelevant in preventing a systemic shock and in mitigating a shock.

One potential criticism of the RFC II proposal is the moral hazard issue, that bank managers would take on more risky assets because the provision of government capital would guarantee that the bank would not fail. Bankers would lose control if they required government capital to remain open.

Conclusion

The key idea of this essay is that U.S. macroeconomic stability would be enhanced if the U.S. Congress established a government agency to provide capital to failing and insolvent banks, which would stabilize the supply of capital to banks after a systemic crisis had led to large loan losses. The rationale is that if the supply of bank capital is not increased to compensate for loan losses, Fisher's debt deflation cycle (1930) would apply and bank liabilities would shrink to correspond with depleted capital.

A few banks failed for idiosyncratic or firm-specific reasons. Most banks, including some very large ones, failed because of systemic shocks. Many banks that failed at the same time were previously considered well-managed. These banks failed because a systemic shock led to a sharp change in the relationship between two different asset classes. There have been four systemic crises since the Federal Reserve was established in 1914. Three were associated with a sharp decline in the price of real estate and one was associated with a sharp increase in short-term interest rates. Hundreds of bank and thrift institutions failed in each crisis. The early 1930s crisis and the 2008 crisis led to sharp declines in nominal and real GDP.

This paper provides an explanation for the Global Financial Crisis of 2008, which reflected the surge in export earnings and the trade surpluses of China and the OEC. The increase in their demand for U.S. securities led to higher prices for U.S. real estate and stocks. Similarly, the increase in demand for securities in other countries led to higher prices for real estate and stocks in these countries. These increases in the prices of real estate and stocks were transient. Prices were likely to decline when inflows fell. A crisis might develop if there was a sharp decline in real estate prices.

DF extended the types of regulatory initiatives appropriate for dealing with bank failure because of systemic shocks. The implicit premise of DF is that the crisis resulted from decisions by U.S. banks to delay increasing purchases of risky securities, rather than from a surge in the supply of credit caused by a combination of increases in capital account surpluses for the countries discussed herein and more expansive monetary policies. DF does not dampen cyclical increases in investor demand for U.S. dollar securities. DF increases the cost of financial intermediation in the "good" years and reduces the perimeter of regulation, but does nothing to abate the severity of the systemic crisis.

The RFC established in 1932 is a model of a government institution that provided capital to failing and insolvent banks. The proposed RFC II would acquire common and preferred shares in failing and insolvent banks. The ownership interest of private shareholders would be diluted. The objective is to save banks as functioning institutions, while replacing senior managers and dismissing the board of directors. The new managers would prepare the banks to be privatized once the macro economy had stabilized.

One of the collateral benefits is that the banking system would be more competitive. The existing arrangement of merging failed banks with more robust competitors reduces the number of banks. This arrangement would be profitable, at least that is the inference from TARP and from the Federal Reserve's investment in IG Group. Monetary policy would be enhanced, since it would no longer be constrained by the adverse impact on financial stability. The costs of bank intermediation in the good years would be reduced because bank capital requirements would be lower.

References

Bagehot. W. (1873). Lombard street. London: Henry S. King and Co.

Board of Governors of the Federal Reserve System (2008a). Bear Stearns, JPMorgan Chase, And Maiden Lane LLC. Available at: https://www.federalreserve.gov/regrefonn/reform-bearsteams.htm

Board of Governors of the Federal Reserve System (2008b). American International Group (AIG), Maiden Lane II And III. Available at: https://www.federalreserve.gov/regrefomi/reform-aig.htm

Central Bank of Iceland (2018). Statistics. Available at: https://www.cb.is/statistics/.

Dowd M (2018). Opinion: Too rich to jail. New York Times, November 19. 2018. Available at: https://www. nytimcs.com/2018/11/17/opinion/sunday/trump-bankers-fraud.html

Fisher I (1933). The debt-deflation theory of great depressions. Econometrica. October 1933, 337-357. Available at: https://fraser.stlouisfed.org/files/docs/meltzer/fisdeb33.pdf.

Jones, Jesse H., and Angly, Edward (1951). Fifty billion dollars: My thirteen years with the RFC (1932-1945), The Macmillan Company, New York.

Statistics Iceland (2018). About Statistics Iceland. Available at: https://www.statice.is/about-statistics-iceland/

U. S. House of Representatives Office of the Law Revision Counsel (1930). United States tariff act of 1930.19 USC Ch. 4. Available at: http://uscode.house.gov/view.xhtml?path=/prelim@titlel9/chapter4&edition=prelim

U.S. Department of the Treasury (2008). TARP Programs. Available at: https://www.treasury. gov/initiatives/financial-stability/TARP-Programs/Pages/default.aspx

U.S. House of Representatives Office of the Law Revision Counsel (2010). Dodd-Frank Wall Street Reform and Consumer Protection Act. Public Law 111-203, 12 USC 5301, July 21, 2010. Available at: http://uscode.house.goV/statutes/pl/l 1 l/203.pdf

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Robert Z. Aliber (1)

Published online: 10 April 2019

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