A Simpler Solution By Arnold Kling

On many occasions, including my Cato paper, I have suggested that we can solve the problem by reducing capital requirements for banks on an interim basis. Nobody seems to be listening to this idea, or even discussing it. It has flaws. But those flaws seem much more manageable than the Paulson plan.

The Paulson plan is based on the clogged plumbing theory. The mortgage assets are stopping up the plumbing of the financial system, so the government has to buy up those assets to unclog the system.

Why worry about the clog in the first place? Because banks have some of these securities, they are marking these securities to market value, which means marking them way down. As a result, their balance sheets show a shortage of capital. To come back into compliance with regulations, they either have to sell new shares of stock (good luck with that) or curb lending. As they curb lending, the economy suffers.

That is why some people say that the solution is to get rid of mark-to-market accounting. Let the banks estimate the “intrinsic” values of their mortgage securities. These values are higher than market values, so that using this alternative accounting the banks’ balance sheets won’t looks so bad. That way, they can keep lending. My problem with that is that phony accounting has a history of keeping failed institutions in business, raising the cost of the subsequent cleanup.

My alternative is to encourage new lending by lowering capital requirements at the margin. Tell banks that loans issued after September 1, 2008, require half the capital of similar loans issued before September 1. Some banks are in such bad shape that even with those lower capital standards they will not be able to make new loans. Fine. You don’t want those banks to grow. But other banks have room to grow, and you want them to grow more than they would under the existing regulations.

As with changing accounting rules, lowering capital requirements ultimately exposes the government funds that insure banks to more risk. That is the flaw in the idea. However, there has to be some risk exposure to tax payers for any policy that encourages bank lending.

The risk exposures in the Paulson plan are many and complex. I worry about adverse selection–the institutions selling the securities to the government know more about what they are worth than the government does. The government is almost sure to get ripped off relative to what it thinks it is buying.

I worry that it will cost the government more to deal with bad mortgage securities than it would cost the private sector. Government is going to have all sorts of political constraints in dealing with this, including pressures to be generous to home borrowers (people who put so little money down that they effectively borrowed their homes).

I worry about the sheer glee that the Left is experiencing as they chorus, “The market failed! The market failed! We need government to take over everything. Dictate executive compensation! Take equity stakes in private firms! Increase regulation by orders of magnitude!”

When your plan is to put up $700 billion to buy assets from private firms, how can this not send a message to the American people that we need socialism? The Democrats who oppose the plan want more socialism, and they probably will get their wish when the legislation is enacted. And Paulson, by emphasizing the drastic need for the bailout, has thrown away any negotiating leverage. They can’t veto a bill that is supposed to save the world.

I don’t think we need socialism. And I don’t think we need the Paulson plan. We need some creative policies with regard to bank capital requirements.