Public sector support of the banking industry

This paper discusses the causes of the current banking crisis, arguing that it is primarily a crisis of confidence and not of bank assets quality, which is far better than either accounting statements or general media portrayal would have us believe. It then examines alternative public sector interventions in the banking sector, distinguishing solvency, liquidity, and funding support (most analyses omit discussion of funding support, which is a serious omission since the root cause of the current crisis has been the problems the banks face in funding long-term assets). The paper recommends using two main tools to combat the crisis. The first is mass purchase and/or insurance of credit assets, focusing on the best quality assets that are undervalued but relatively low risk. It may be easier for this to be undertaken by central banks in the first instance. They could easily buy, for example, the majority of the U.S.$5.4 trillion outstanding stock of senior tranches of structured and loan backed securities. The second stage is the introduction of longterm government backed insurance (effectively replacing the failed protection offered by the mono-lines and AIG) whenever long-term assets are financed using short-term wholesale borrowing. With this backing the overhang of structured credit can be returned to the private sector. Such long-term insurance can help support strong growth of bank lending and economic recovery post-crisis and help establish a less dysfunctional future relationship between government and the banking industry.