The way out

Chicago Booth economist Anil Kashyap offers a starting point for a banking-industry rebound plan.

By Brooke E. O’Neill, AM’04

Photography by Dan Dry

Although the U.S. economy is starting to show signs of recovery, its vital statistics remain alarming. This past June national unemployment rose to 9.5 percent, up nearly 4 percent from June 2008. In Michigan the jobless rate soared to 15.2 percent, making it the first state to pass 15 percent unemployment since 1984. Across the country, job insecurity and income stagnation further dampened consumer spending—July figures from the Labor Department showed the smallest three-month average increase in hourly earnings since 1964.

IMAGE: Anil Kashyap
Anil Kashyap warns banks against counting on a quick economic recovery.

Even Chicago Booth economist Anil Kashyap, who has spent more than 20 years researching banking, monetary policy, and financial crises, was taken aback by the recession’s depth. The Edward Eagle Brown professor of economics and finance admits that when he lectured about off-kilter housing markets in early 2007, he “had no idea that it was going to turn into this.” Kashyap wasn’t alone. When Morgan Stanley issued a recession alert in December 2007—the month the slump began, as the National Bureau of Economic Research (NBER) later confirmed—many accused Federal Reserve Chairman Ben Bernanke of overreacting when he significantly cut interest rates to jumpstart the economy.

“He should be viewed as a hero because at least he diagnosed this quickly,” says Kashyap, a macroeconomist who has consulted for central banks worldwide. Kashyap soon issued his own warnings, writing in a March 19, 2008, Financial Times op-ed that the collapse of investment firm Bear Stearns meant the credit crisis had entered a “new, more dangerous phase.” The subsequent nationalization of Fannie Mae and Freddie Mac, bankruptcy of Lehman Brothers, and government loan to insurer AIG, he argued, hastened the downward spiral.

Now a shortage of capital threatens to drag out the banking recovery. Although it’s hard to know exactly how much banks have set aside to protect themselves against record unemployment and reduced spending, Kashyap believes it’s not enough. A consultant to the Federal Reserve Bank of Chicago, he’s seen the inner workings of the financial system as an economist for the Federal Reserve’s Board of Governors. He believes banking institutions are, erroneously, still hoping for a rapid turn-around in the economy. With so much “negative momentum,” he predicts undercapitalized banks, when they do take on new loans, will impose higher-than-average interest rates, further stifling economic growth.

Thus far, Kashyap says, the federal government’s response to the credit crisis—the Troubled Asset Relief Program (TARP) and corporate bailouts—bears an “eerie resemblance” to how Japan handled its decadelong financial crisis in the 1990s. A co-organizer of the NBER’s working group on the Japanese economy, he has written two books on its history and is advising the Japanese cabinet office on a retrospective of national macroeconomic policies over the past 25 years. Often called the “lost decade,” Japan’s financial crisis and subsequent slowdown began, as in the United States, when a spike in real-estate and stock prices created an economic bubble that burst, precipitating a credit crunch.

The resulting market turmoil prompted a wave of government capital assistance, which Kashyap compares to the first version of TARP, distributed “more or less indiscriminately,” with little differentiation between strong and weak institutions. A second round of Japanese funding was more organized, but even after three years the government failed to recapitalize banks to the point where they could resume normal lending. Institutions morphed into “walking wounded,” continuing to provide loans to their weakest customers, artificially propping up “zombie firms” and distorting competition. Productivity continued to slow, precluding economic recovery.

Kashyap’s recent analysis of 120 troubled Italian banks that experienced sharp drops in profitability between 1988 and 2002 further underscores the importance of managing risky clients. In this preliminary study, Kashyap, who sits on the board of the Bank of Italy’s Einuadi Institute of Economics and Finance, found that only one-third of the banks ultimately recovered. Compared to their unsuccessful counterparts, institutions in this group made fewer loans to clients likely to default. The findings, he says, suggest that recovery, while in part determined by outside factors such as the overall business climate, also rests on factors banks can control.

Changes to governmental oversight will doubtless be part of banks’—and the economy’s—recovery, but Kashyap warns that hastily revamping financial regulation in the midst of this crisis would do more harm than good. “When a house is on fire, you put all your initial effort into putting it out,” he wrote this past March in the Financial Times. “Only after the fire is squelched do you redesign the sprinkler system.” Because no one knows exactly what the financial landscape will look like once the economic trouble subsides, he wrote, instituting sweeping regulatory changes too early could bind the industry to measures that fail to address postcrisis realities.

An effective regulatory approach requires global consensus and coordination with central banks worldwide. Otherwise companies may simply move certain operations abroad to avoid American regulations. “It is much more costly to close loopholes” and fix other weaknesses in the system “than it would be to get regulations right and harmonized at the outset,” says Kashyap, who advocates a progressive, staged reform similar to that enacted after the 1980s savings-and-loan crisis. Instituted over two years, the legislation strengthened the industry by mandating banks to meet higher capital requirements.

There is one step Kashyap believes all financial institutions should take immediately: prepare for their own death. Known as a “rapid resolution plan” or “funeral plan,” this measure, part of the Obama administration’s regulatory-reform proposal, would require banks and other financial firms to have a clear strategy for dissolving if necessary. The string of government bailouts—Bear Stearns, Fannie Mae, Freddie Mac, AIG—was motivated partly by the fact that no one knew what would happen if the behemoths failed. “The bankers know this and can exploit the fear of the unknown,” wrote Kashyap in the June 29 Financial Times. The requirement would force management to map out, for example, how many days it would take to cease operations in the event of a collapse. Unlike other potential reforms, regulators could implement this change immediately, without legislative intervention.

“This simple step,” writes Kashyap, “would have both short-run benefits if another wave of panic occurs and longer-term payoffs that would complement other reform efforts.” It’s not a panacea, he says, but it’s a start.

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