How to Rescue a Banking System

I’ve read or heard of many ideas suggested by many different people to rescue the banking and financial system in the U.S. My current perception is that any of these ideas would be preferable to whatever the Bush administration did and what the Obama administration might do. Breakingviews.com has an interesting good bank/bad bank idea:

The “bad bank” schemes being considered by President Obama’s administration have a central flaw: they involve government-backed entities buying banks’ dodgy assets, which in turn requires the immediate valuation of assets that trade at distressed prices, if at all. That increases the likelihood of error, risks rewarding obfuscation, and could leave taxpayers in a hole. There are better ways to structure bad banks.

To work properly, the incentives of all parties should be aligned as closely as possible. Bank rescues must distinguish between banks that are troubled but can be saved and those that should be allowed to die. As little as possible of the industry should be taken into public ownership. And taxpayers must be properly protected, so that the bad bank process does minimal damage to their economic interests.

There is a way to meet these objectives: allow banks to sell any assets they want, and have the government’s bad bank acquire them on a consignment basis with no initial cash outlay. Banks would achieve a return on their consigned assets only as the bad bank sold them or allowed them to mature. This “consignment shop” structure removes the initial valuation challenge that bedeviled the original concept of the Treasury’s Troubled Asset Relief Program.

Read the full article. I’m not sure if their proposal would work or not, but it sounds simple and I am definitely appreciative that Breakingviews recognized the importance of incentives in just the second paragraph of their article. The wrong kind of incentives got us into a financial mess, so I reckon that a solution must have the right kind of incentives if we are to get out of this mess sooner rather than later.