Banking on a Solution

Banking on a Solution

With a new administration often comes new ideas, but it appears the Obama administration is working on yet another version of a financial industry rescue – let's call it TARP 3.0. The main piece of this package would be an "aggregator" bank that would serve as a dumping ground for banks' toxic assets that have spawned the logjam in credit markets in the first place. Some analysts are referring to the plan as a good bank/bad bank setup, because it would allow banks to unload the deteriorating assets that have depleted so much capital from their balance sheets, which would then give them ability to start with a clean slate.

An astute reader might notice that this plan is very similar to the original TARP (it is, basically); however, this time the FDIC will likely run the bad asset collection facility rather than the Treasury itself. Unfortunately, this new old idea also has the same drawback as it did when first proposed, namely: what price should the government pay for assets for which no market currently exists? If the price is too low, a large number of banks could be pushed into insolvency, even those that had relatively healthy capital reserve levels. By contrast, pay too high a price and taxpayers could be left holding the bag if these assets continue to lose value (or worse, end up completely worthless).

No silver bullet exists that will stop the financial crisis dead in its tracks, so policymakers are left with several unattractive options: 1) continue to periodically infuse banks with additional capital for an indefinite length of time(the dreaded zombie bank scenario); 2) absorb bad assets from financial institutions; or 3) outright nationalization of failing institutions. Some analysts feel a combination of these three choices holds the most promise (see here and here).

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