On Tuesday 17th March 2009, Professor Kevin Dowd gave the Libertarian Alliance’s 2nd Annual Chris Tame Memorial Lecture, “A Libertarian View of the Financial Collapse”, which I attended at the National Liberal Club in London.

http://video.google.com/videoplay?docid=2495820480786986515&hl=en

There is a transcription with notes and appendices at http://www.libertarian.co.uk/lapubs/econn/econn111.htm.

Despite its title, Professor Dowd’s lecture did not focus on the causes of the financial crisis. For that, I would recommend “The Financial Crisis: Causes and Possible Cures” by John Allison, CEO of BB&T, on 29th January 2009.

Professor Dowd did identify statist measures which contributed to the banking crisis: limited liability laws which encourage irresponsible risk taking; the deliberate destruction of the convertible pound, which allowed inflation; state-mandated deposit insurance; and central banking. All this is the opposite of a free market, far from a laissez-faire system which some people claim it to be.

He criticised the reappearance of Keynesianism, which he described as “discredited and abandoned in 1976″. He criticised the government response so far, pointing out that credit is tight because confidence is lacking, not because interest rates are too high, and that printing money will erode confidence further. Erratic government action, such as further bailouts when previous ones didn’t work, also erodes confidence.

However, most of Professor Dowd’s lecture was on how to fix the banks. Our objective is “a safe, stable and efficient financial system”. “This can be achieved through a system of laissez-faire, or free banking.” Our objective is free banking on a sound commodity based currency.

We could apply laissez-faire immediately, in the middle of the crisis, and let market forces purge the rot out of the system. This sharp but short shock, says Professor Dowd, would be better than what governments actually did do. However, it would be politically difficult.

More importantly, we can do better.

The Bank Recovery Programme

Professor Dowd proposes a “bank recovery programme”, involving no state guarantees and no bailouts, which would deal with the fundamental structural problems of the banking system.

The key question is: How do we deal with financially distressed firms?

Professor Dowd says that we should simply apply receivership law to banks just like any other firm. A firm’s liabilities should match its assets. If a firm’s liabilities are greater than its assets, it should go into receivership. The aim should be to restructure a bank’s balance-sheets so the firm is adequately capitalised, and hopefully return it to operation. Assets are written down, and creditors are paid off first. Shareholders get what is left, if anything. If creditors have to take a hit, then shareholders lose everything. If the firm is still potentially viable, it is recapitalised with new shareholders and returned to operation in a financially healthy state.

In the case of banks, there is share capital, and deposits (debt). The debt obligation is fixed in nominal terms. If a bank does not have enough assets to meet its debt obligations, the depositors make a loss, and the shareholders are wiped out.

This programme deals with people who claim banks are too big to fail. It allows us to fix the banks without them failing, yet without a bailout; without taxpayer involvement.

The programme treats banks just like any other firm. Some people claim that “banks are different”. Yes, but not in any relevant way. Existing bankruptcy law should cope just fine with banks. Indeed, before the present crisis, the authorities were saying just that: that we were operating in a “non-zero failure regime”.

There is one way in which we must treat banks differently from other types of firm. “Any receivership solution to a distressed firm needs to take into account the nature of the firm’s business”. If an electricity provider goes into receivership, you don’t want to switch off the the generators while the firm is sorted out. If a hospital goes into receivership, you don’t close it down while you sort the accounts out.

Banks are central to credit system for the rest of the economy. Banks are central to the payment system. So receivership must be implemented carefully.

The government has placed an obstacle to receivership: deposit guarantees. This reassures depositors (with a catastrophic long term cost). But it prevents receivership operating normally. It prevents depositors taking a hit.

So the government must rescind the deposit guarantee at the same time as implementing the receievership package.

They should do it over a weekend. On Friday evening, the government should inform banks that the deposit guarantee is immediately rescinded. Any bank that was confident could choose to weather the possibility of a run on its deposits. Other banks would go straight into receivership. The receivers would move in overnight, and work quickly to minimise disruptions to the wider economy.

Cash withdrawals would be limited for the duration of the operation. It is important to keep the banks’ assets in the banks while we devalue them. Assets would be written down quickly according to prepared write-down formulae for different asset classes. These wouldn’t need to be particularly accurate: indeed, it is best if write-downs are harsh, worst-case valuations to be on the safe side.

Now comes recapitalisation. Shareholders lose everything. The new capital comes from deposits: some deposits are converted into shares.

For example, imagine a bank with £80 of assets and £100 of deposits (debt) on its books. The shareholders are wiped out. The depositors lose £20. The receivers then judge how much share capital is needed, and convert a proportion of deposits into shares. The depositors become the new shareholders.

We could protect smaller depositors to make the plan politically easier.

On Monday the banks reopen.

Hopefully, the market would realise assets were worth more than they were valued at, and share values would rise. That’s the advantage of harsh write-downs. Depositors would make a loss on their deposits, but a capital gain on their new shares. The capital gain would increase as confidence returns.

Shareholders should take the hit. After all, what has the taxpayer got to do with it?

With a good capital base, the banks would be healthy again.

Here is a letter Professor Dowd wrote to the Telegraph on Sunday 25th January 2009:

SIR – The Government’s policy towards the financial crisis is clearly not working. Having “saved” the banking system with the big bail-out last October, it now turns out that the banking system needs another big bail-out three months later, and the plunges in the banks’ share prices last week suggest that this second bail-out is not working either.

The Government’s blundering is leading towards the piece-by-piece nationalisation of the banking system, with no thought-through solution to the underlying problems.

Any solution has to provide a framework within which banks can restructure their balance sheets and restore their financial health. Were these institutions anything but banks, the obvious answer would be for them to go into receivership. Their assets would be written down and creditors’ claims on those assets would be cut; they could then be recapitalised and returned to normal operations.

Yet, radical as it might appear, this same receivership-recovery model can also be applied to banks. It could be implemented via formal receivership, as existing law provides for, but could also form the basis of a government rescue package that would stop further losses being inflicted on taxpayers.

The key elements would involve: write-downs on assets; write-downs on banks’ debts (for example, swaps of deposits for equity, with exemptions for smaller depositors); and measures to minimise disruption to banks’ ongoing ability to provide both credit and payment services (including ensuring that the rescue took place over the weekend).

The combination of asset write-downs and fresh equity would restore confidence and put the banks on a sound footing again.

Prof Kevin Dowd
Centre for Risk and Insurance Studies, Nottingham University Business School

Johnathan Pearce also has a write-up with comments over at Samizdata.