Against New Good Banks

Paul Romer’s op-ed on starting up new good banks rather than trying to rescue existing institutions has gotten quite a lot of play in the blogosphere, maybe because of his famous last name; he shouldn’t be confused, however, with David "husband of Christy" Romer.

I’m someone who thinks that bank nationalization is a good idea, and as such there’s something to like in any proposal which helps the idea of state-owned banks enter the mainstream. But of all the nationalization proposals, this one seems to me to be one of the weakest.

For one thing, it’s far from clear that there’s a shortage of "good banks" in the US right now. One of the big differences between the US and Europe is that the US has many more banks; even the huge ones don’t have anything like the market share that big European banks do, and there are thousands of small and tiny banks — not to mention credit unions — which have really no European counterparts at all. Many of them — and even many pretty big banks — are doing fine.

Putting government capital into new "good banks" would create unhelpful competition for the existing good banks, while providing no help whatsoever for the existing bad banks. Remember that the single biggest problem with too-big-to-fail banks is that they can’t be allowed to fail. So even if setting up good banks was a good idea, it would be an insufficient idea, since the big bad banks would still need to be rescued: there’s simply no way we can afford a big bond default by the likes of Citigroup or Bank of America, let alone even hint that their uninsured depositors might be in danger.

And Romer ignores another key aspect of the credit crunch: yes, it’s true that underwriting and lending standards have tightened up substantially, and that the supply of credit is much smaller than it was. At the same time, however, the demand for credit has also plunged. The US might need credit to start flowing again, but you can’t force people to borrow money in this economy — especially not when every news headline reinforces the prudence of saving money rather than borrowing it.

Oh, and one other thing: setting up a new "good bank" right now is a fraught prospect. Banks, fundamentally, are maturity transformers: they borrow short and they lend long. As a result, the single most dangerous time to launch a huge new lending program is when interest rates are lower than in living memory. And the market knows it: it’s not going to have much more confidence in the "good banks", over the long term, than it does in the current bad banks.

For all these reasons, and many more, I think that outright nationalization of the existing bad banks is a much better idea than trying to reinvent the entire banking system from scratch in a few short years. There might not be a lot of useful institutional knowledge in the old bad banks — but there’s surely more than there is in banks which haven’t even been founded yet.