Tuesday, June 29, 2010

Counterfactual: US government uses bailout funds to create a bank

Note: This is counterfactual. So US government did not actually do this but I am just guessing what would have happened if they had done it.

During the crisis, US government initiated a bailout of approximately trillion dollars. Out of this about USD 700 billion was under TARP regime. What would have happened if these funds were allotted as equity in starting up a new bank -say US treasury bank or T-bank for short.

T-bank would be mandated to have 50% fresh lending and 50% buying impaired assets through bankruptcy procedures. Every other bank in US and post offices would be required to have a desk for T-bank.

Since the creation of this bank was forced on to the government, government will not pay the other bank branches for use of their office premises. The postal offices should be readily accessible to the government any ways.

T-bank would finance mortgages based on new assumptions about price. The price may be decided as average of past 20-year prices or current prices whichever is lower (or some such super conservative metric). T-bank will only finance 75% of the value of the house so calculated.

Loan against collateral will be instituted in similar to mortgages. An assessment of recoverable value of the collateral will be determined. It will be marked down by certain percentage to ensure full loan recovery in case of default. It will also check for equity contribution from promoters. Promoters will be required to give personal financials for verification. The financials will be checked to verify if promoter equity is indeed equity and not debt masquerading as equity.

T-bank would initiate a simplistic credit card program. Customers will get one-month credit at fixed rate of 10% (or some such number accounting for risks). T-bank credit card will not have fees.

As per the mandate, T-bank will be compulsorily and irrevocably privatized after 20 years at the maximum.

I believe this initiative would have immense advantages.
  1. Since the costs are higher large businesses will not use this service leaving this money free for use by small businesses. T-bank, if so required, can be mandated to lend to SME and individuals only.
  2. It will channel the money flow directly where it might make viable contribution. Creating money in balance sheet of large banks is like pushing on a string. The money simply does not flow to the grass-roots.
  3. The current situation prevents eligible borrowers from borrowing because of the crunch. This is the best time for such borrowers to start enterprises and take risks.
  4. The charges may be higher, but treatment will be fair so competitive forces may start assisting systemic cleanup on credit card and loan frauds.
  5. It neutralizes the possibility that banks may hold the financial system hostage.
  6. It presents no moral hazard since it does not interact with banks' assets at all. 
  7. Further, since treasury or government is backing this bank, it has lower risk. Thus it should be able to access funds at very low rates.
  8. The efficiency of this money, or the impact this money creates, will be far higher thus size of bailout liability will be smaller.

Interesting isn't it?