Should the FDIC give bank creditors a haircut?
The House Financial Services Committee has passed the Miller-Moore amendment to the current reform bill, which limits the claims of secured creditors to failed banks (called ‘haircuts’ in financial slang). Those arguing against the idea say that banks will have a harder time raising capital, which will reduce the flow of credit into the economy. Others see benefits in the amendment, including an increased honesty in the system which will make it more obvious when banks get into trouble. On the Creditslips blog, Bob Lawless acknowledges that capital formation will be slowed, but likes the notion that the FDIC will be protected from losses incurred as a result of banks over-invested in risky assets. Lawless’s blog post provides a cogent explanation of why, in this case, the benefits are far greater than the costs:
Proposals for Haircuts at the FDIC
FDIC-sponsored haircuts have become a hot item in the blogosphere. My wife used to work for the FDIC, and I smile every time I hear the term as I think about the building on F Street with a big barber pole in front of it. Here, the term is not being used in its hirsuted sense but as part of the colorful vernacular that surrounds insolvency work. A “haircut” describes a situation where a creditor is paid less than that to which they are entitled.
The FDIC proposal comes from Representatives Brad Miller and Dennis Moore and would limit the recovery of secured creditors to 80% of the value of their collateral in FDIC takeovers of failed banks. (I can’t seem to locate the original text of the proposal on the Internet, but it has been widely reported.) Academic types will remember a similar proposal from Professor Elizabeth Warren back in the 1990s that would have limited recovery to 80% of the collateral’s value. While Warren’s proposal would have applied to many types of secured lending (at that covered by Article 9 of the Uniform Commercial Code, the current proposal is limited to failed financial institutions taken over by the FDIC.
The usual criticism has arisen in the usual places, namely that the latest proposal will discourage capital formation in banks. In turn, it is said that banks will lend less. Growth will be deterred. And we’ll see even more gruesome scenarios involving the cross-breeding of dogs and cats. All of that might be true–well the dogs-and-cats part is less likely–but these criticisms miss the point. The question is not whether we like capital formation and economic growth but whether the costs are worth the benefits. The costs here come from the moral hazard that is created by asset partitioning.
The usual criticism has arisen in the usual places, namely that the latest proposal will discourage capital formation in banks. In turn, it is said that banks will lend less. Growth will be deterred. And we’ll see even more gruesome scenarios involving the cross-breeding of dogs and cats. All of that might be true–well the dogs-and-cats part is less likely–but these criticisms miss the point. The question is not whether we like capital formation and economic growth but whether the costs are worth the benefits. The costs here come from the moral hazard that is created by asset partitioning.