Column : Who will bail the cat

Written by Michael Walton | Michael Walton | Updated: Sep 26 2008, 05:53am hrs
The weekend of September 20 th witnessed two contrasting headlines in the wake of the latest response to the Wall Street crisis, a proposal by the US Treasury to buy bad assets of troubled financial institutions. The front page in the Financial Times announced: Global markets roar in approval. The front cover of the US weekly Time Magazine said: How Wall Street sold out America. They had a party. Now youre going to pay.

So is this a necessary systemic response to save the financial system, or an example of privatization of benefits and socialization of losses Theres a case for both views.

The value of toxic assets is so uncertain, markets so illiquid, and financial institutions so inter-connected that there is a real risk of financial implosion. A case by case approach has not worked. Recent actions to let Lehman Brothers fall, but take over the insurance company AIG, were reasonable calls under crisis conditions. Yet they increased uncertainty, when the financial system desperately needs confidence restored. A systemic solution is necessary.

But the other view is also compelling. During the boom the financial system made high profits, brought handsome gains to shareholders and seemingly obscenely high incomes for successful participants. There were apparent benefits in financial inclusion to citizens who would have been denied a mortgage or other credit in earlier periods. The US economy grew faster on the back of the housing boom and credit expansion. But these benefits were modest compared with the gains to financial sector insiders.

Crises more commonly occur in emerging markets, such as Indonesia or Mexico. There the characteristic pattern is of unequal gains during the pre-crisis credit boom, followed by an unequal bailout to save the system, benefiting financial sector insiders, with taxpayers and workers picking up the bill. Can the US do better

The challenge is to design a workout that restores market functioning whilst ensuring shareholders bear a lot of the pain, in order to reduce incentives for future excessive risk-taking.

It is useful to put this in context. Every market-based system depends on mechanisms for managing risks, incentives to innovate and information dissemination. These shape the pace and pattern of market development, and the distribution of rewards. The US financial system had bad incentives for risk management and innovation and obfuscated rather than revealed information. There was intense innovation in financial instruments for reallocating risk. Securitization allowed primary loans, such as subprime mortgages, to be repackaged, sold off and form the basis for derivatives. Insurance got into the action through providing cover via credit default swaps.

Yet the financial instruments were so complex that they hid rather than revealed information. Instead of efficient reallocation of risk, there was a massive failure to value and price risk accurately, a failure of the banks, insurance companies and rating agencies alike. This created a financial system that is too large, has too high returns, and distorted internal incentives. Lack of regulation of the non-bank part of the system added to the problem, especially given the informational obfuscation. Weak regulation was supported by ideology, especially when the influential were gaining, but weak understanding also mattered. For the most part, players were not deliberately fooling the public, they were fooling themselves that this was a viable system.

When the true risks of subprime mortgages emerged, the house was revealed to be built on sand, and the extraordinary financial inter-connectedness led to systemic effects, with the modern equivalent of bank runs, loss of confidence, a credit freeze and a flight to quality.

So is a takeover of toxic assets the answer The big problem with a bailout is that no-one knows the value of the assets: financial firms have incentives to unload as many of their bad assets as they can into the toxic dump. If prices are high enough, those with the largest quantity of bad assets will benefit most, at the cost of taxpayers.

Many commentators have suggested an alternative strategy: tackling the undercapitalization directly through some combination of mandatory freezes on dividends and equity issues for stronger firms, and government investment in preference shares. This would restore capital, providing the basis for market-based resolution of the asset problem and a process in which stronger firms buy up weaker ones. More of the pain would then be borne by financial insiders.

The issue is not that markets are necessarily bad or regressive. Yes, a Republican Administration of the United States is hugely increasing its direct involvement in the financial sector, and is extending regulation to under-regulated parts of the system. The first may be unavoidable, and the second desirable. But this as an example of the need for institutional designs that respond to market failures, in the interest of market-based development. This requires that the state design regulatory structures that foster the right kind of innovation and risk-taking, not the wrong kind.

The author is at the Harvard Kennedy School, the Institute of Social and Economic Change, and the Centre for Policy Research.