What's Wrong with Deleveraging? By Arnold Kling

In a previous post, a commenter asked a good question about what bothers me about deleveraging.

Deleveraging in the nonfinancial sector means that consumers buy less on credit and firms use less debt financing. That is obviously necessary, because we had excess leverage before.

Deleveraging in the financial sector means that banks and bank-like institutions try to hold fewer risky long-term assets and issue more risky long-term liabilities. That is a bad thing, in my view. Within the financial sector, rapid deleveraging is a beggar-thy-neighbor situation, in which firms destroy one another’s liquidity. The demands for collateral to back credit default swaps are a prime example.

However, the financial sector became excessively leveraged in recent years. So what is the solution? I believe that the solution is to aggressively shut down insolvent institutions. In the case of banks, you pay off the depositors and try to make the best deal you can for other creditors (usually, that means selling the bank and writing down some its debt).

The strategy of shutting down institutions is not perfect. It scares the bleep out of people who have bonds or preferred stock in similar institutions. It makes it hard for banks to raise capital. So you have to give them some capital forebearance–let their capital ratios get low, as long as you think they are not hiding some really big losses somewhere.

There is no perfect way to get rid of excess leverage in the financial sector. But I think that getting rid of weak institutions works better than propping them up. When you prop them up, they continue to participate in the beggar-thy-neighbor process that is the ugly side of financial sector deleveraging.