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Are Bad Banks the Solution to a Banking Crisis?* Jonathan R. Macey** SNS Occasional Paper No 82 June 1999 * This study is a background paper to a report evaluating Securum, the organisation that was created in 1992 to manage the non-performing loan portfolio of Nordbanken, one of the largest banks in Sweden. In 1997 Securum and SNS reached an agreement that SNS was to undertake an independent study of the operation of Securum and whether an organisation like Securum is a suitable one to handle banking crises. SNS turned to three Swedish academic researchers, Clas Bergström and Peter Englund, Professors of Finance, Stockholm School of Economics, and Per Thorell, Professor of Law, Uppsala University (now at Ernst & Young), to undertake the evaluation. Funding has been provided by Venantius, which in 1997 took over some remaining parts of Securum, and Nordbanken. The views expressed in this paper are, of course, those of the author. ** Cornell Law School, Myron Taylor Hall, Ithaca, New York 14853, USA. E-mail: firstname.lastname@example.org. 1. Introduction Sweden is only one of a large number of countries that have faced severe and systemic problems in the banking sector during the past fifteen years. In all, ninety countries have experienced significant episodes of banking collapse during this period. Twenty of these episodes have produced bailout costs for governments in excess of ten percent of their country’s GDP.1 As these bailouts are ending, finance ministries and international economic organizations find themselves in the midst of a furious debate over the appropriate strategy for resolving the Asian financial crises. The recent intervention by the Board of Governors of the Federal Reserve System in the United States to bail out a large hedge fund, Long Term Capital Management, has further contributed to the debate about the proper scope of regulation in resolving troubled financial institutions. The Swedish government is quite proud of the way it handled the banking crisis of the late 1980s. It is holding out the strategies utilized during this period as a model for the rest of the world, particularly Asia.2 The critical feature of the Swedish strategy for resolving its banking crisis was the splitting of distressed financial institutions into so-called “good” banks and “bad” banks. This decision, which was the cornerstone of the Swedish approach to its banking crisis, merits further study before it becomes the international model for future bank failure procedures. The purpose of this article is to examine the good bank/bad bank strategy in general and Swedish bank insolvency practices in particular in order to provide an independent assessment of Securum’s performance and of the possibility of exporting the Securum strategy to other economies facing financial crises. This Report is divided into three parts. The first consists of a general discussion of the costs and benefits of the good bank/bad bank strategy for resolving troubled banks. The second consists of an analysis of the performance of Securum and its sister institution, Retriva, which were the entities established to take over the bad assets of Nordbanken and Gota Bank, respectively. Lastly, the report considers 1 Charles Calomiris, Harmful Bailouts, American Enterprise Institute, January 1998, On the Issues. 2 See Lars Heikensten, Financial Crisis-Experiences from Sweden, speech at a Seminar arranged by the Swedish Embassy, Seoul, Korea, July 15, 1998. 5 whether the Swedish experience with bad banks is generalizeable, that is, whether it can readily be utilized in other bank failure situations. The major conclusions of this Report can be succinctly summarized. First, while the good bank/bad bank strategy represents a viable strategy for many types of financial institutions, it is possible to overemphasize the value of this strategy. Good bank/bad bank restructurings simply involve the separation of the good assets of a bank from the bad assets during a time of crisis, and calls for separate management of the disposition of these two categories of assets. Thus, if one divides the period of a banking crisis into two parts, the crisis prevention and crisis management stages, the good bank/bad bank strategy addresses only the crisis management stage. Whatever the benefits associated with this crisis management technique may be one cannot ignore the critical crisis prevention stage. This is not to say that good bank/bad bank crisis management strategies are uninteresting or unimportant. Rather, the point is that they are not a panacea. In fact, by definition, these strategies are only used when problems exist. Clearly, the prevention of a banking crises is always the first-best strategy. Crisis prevention requires early intervention. One of the primary findings of this Report is that the earlier that bank intervention occurs, the more difficult it will be to identify, categorize, sort, and value bad assets. Consequently, early intervention makes the task of the managers of bad banks more difficult. In contrast, when intervention comes very late, after the assets on a bank’s balance sheet have had time to deteriorate, even though the overall costs of a bail-out become more costly, the task of the managers of bad banks is made considerably easier by the fact that it is relatively easy to identify the bad assets. The main point made in this Report about the trade-off between early intervention and the likelihood of success in implementing a bad-bank strategy implies that the fewer resources that regulators devote to crisis prevention, the easier their job will be later when it comes to crisis management. Thus, when evaluating the performance of a regulatory regime it is probably a mistake to view crisis prevention and crisis management in isolation. These components of banking crisis administration must be viewed together in order to completely understand how well regulators have performed. While this observation may appear to be obvious, analysis of the regulatory responses to the Swedish financial crisis has isolated crisis 6 prevention and crisis management, and has focused, understandably, on crisis management.3 Similarly, when we evaluate Securum’s performance we must recognize the fact that there may be incentives inherent in Securum’s good bank/bad bank strategy that could cause the success of the program to be exaggerated. Specifically, those bank managers who were responsible for selling off the bad assets may have had incentives to aggressively write-down the value of those assets in the initial stage of crisis management, thereby causing the economic success of the bail-out to be overstated. This Report suggests that competition for the bad bank assets may provide a more objective measure of the bad banks’ balance sheets with which a more accurate assessment of the crisis management stage program could be calculated. In addition, this Report observes that successful bank crisis management requires that there be a solid political consensus among the various groups affected by the crisis. Because effective (i.e. early) crisis prevention makes effective crisis management more difficult, and ineffective crisis prevention makes the job of crisis management more manageable, it is clear that it is far easier to achieve the political consensus necessary for an effective crisis management stage once there is general agreement about the nature and scope of the problem and the need for solutions. By contrast, at the crisis prevention stage it will be far more difficult to achieve political consensus because there is likely to be meaningful disagreements about the desirability of intervention. This conclusion stems from the observation that when there is substantial disagreement about the value of a distressed bank’s assets, it will be harder to reach political consensus about how those assets should be resolved. Of course, the problem of bank failures, and the bank failure crisis itself, are not unique to Sweden. Over the past twenty years, countries all over the world have been forced to find solutions to the problem of failed banks. According to Bengt Dennis, ex-governor of Sweden's central bank, between 1980 and 1996, “more than two-thirds of the 181 members of the International Monetary Fund experienced serious banking problems.”4 These failures have 3 Lars Heikensten, supra note 2. 4 Confidence Seen as Key Factor Swede Outlines Way to End Crisis, NATION (Bangkok), Dec. 11, 1997. As reported: Dennis noted that Chile required 30 per cent of its gross domestic product during 1981–1987 to tame a crisis; Venezuela, 20 percent in 1994; Spain, 15– 7 forced policy-makers and academics to address the causes and consequences of bank failure. 2. Some Preliminary Observations About Bank Failure in Economic Theory Contrary to popular belief, the failure of an insured depository institution does not reflect a failure of the banking system as a whole or even a failure of the regulatory system that was constructed in the aftermath of the wave of bank failures stemming from the collapse of the stock market in 1929.5 As with other sectors of the economy, the failure of a financial institution indicates one of two states of affairs: either the firm has not responded to market forces with a satisfactory mix of price and product performance relative to its competitors in the industry or else the firm’s product is not in sufficient demand by consumers to justify its production in the first place. In either case, termination of the firm's operations represents a net social gain. In a market economy, when an enterprise fails, the resources previously devoted to a firm will find other, more efficient uses.6 As a result, the existence of failing institutions may be a sign of health rather than a sign of malaise because it indicates either that innovation is driving obsolete firms out of the industry, or that competition is driving 20 percent in 1977–85; Mexico, 15–20 per cent in 1994; Sweden, 4 per cent in 1990–1993; and the United States, 2 per cent in the 1980s. Thailand is expected to spend about Bt800 billion to end this crisis or around 15–20 per cent of GDP. Id. 5 See Tussing, The Case For Bank Failure, 10 J. L. & ECON. 129, 143 (1967). 6 As financial intermediaries, banks directly affect the allocation of financial resources by other firms. As Tussing notes: a financial intermediary has the potential not only for misusing the labor, invested capital, and other factor inputs it uses directly, but also for distorting the use of resources by business generally. If it is desirable that an inefficient manufacturing establishment fail, so that the resources devoted to it can be made more useful to society, it is doubly desirable that an inefficient bank fail. Not only will the resources directly devoted to it find more useful outlets, but the increased efficiency in financial processes which results can mean that loans are made more nearly in accordance with social priorities, that local and regional economic growth are not retarded by underbanking, and that interregional financial flows are not impeded through the petrification of inept locational decisions. Id. at 146. 8 inefficient firms out of the market. These considerations suggest that in a developed market system bank failure is not necessarily problematic. Concerns with bank failure, therefore, must be based on some special problems that alter our customary reliance on the valuable economic role played by business failure. A number of bank-specific concerns have been suggested: the fear of bank runs; the loss of society's and depositors' wealth; and the costs of bank failure for the system of deposit insurance, which itself is a response to perceived problems with bank failures. Yet, if the government intercedes inefficiently, such as by keeping a failed institution alive for too long, the costs of bank failure will rise unnecessarily, and the benefits may not fully be obtained. Similarly, even where bank failures serve some worthwhile market function, if the market can find a means for minimizing the losses associated with a failed or failing bank and maximize the value of performing assets in that bank by emancipating them from the binds of the non-performing assets, the benefits of failures may not be obscured. The most important such method has become known as the good bank/bad bank restructuring strategy. This strategy minimizes the losses from bank failures, including the losses associated with the erroneous deployment of bank assets. At the same time, the strategy can be combined with elements of market discipline that ensure that the state does not either subsidize excessive risk-taking or deprive market participants of the incentives to monitor bank management. 3. The Good Bank/Bad Bank Framework For a failing bank, “the good bank-bad bank structure may represent the last, best chance for assuring survival. It is unequaled as a means of quickly curing the debilitating problem-asset disease.”7 Good bank/bad bank restructuring plans take a variety of forms, but all involve the separation of performing and non-performing assets of a financially distressed bank into separately managed financial institutions. Good bank/bad bank restructuring plans place low quality assets into a special asset company, which is dubbed the “bad bank.” This “bad bank” can take any one of a number of forms, including a liquidating bank, a partnership, a trust, or 7 Timothy Hurley, Good Medicine: Bad-Bank Plans, AM. BANKER, June 17, 1992, at 4. See also Peter S. Rose, The Good Word on “Bad” Banks, CAN. BANKER, Nov.–Dec. 1989, at 42 (arguing that the creation of bad banks have been responsible, in part, for the recovery of several leading U.S. banks). 9 a corporation.8 The other entity, the “good bank,” retains and manages the performing assets. This strategy is intended to serve a number of business purposes: The strategy allows a bank to jettison its troubled assets into a limited-service bank or liquidating trust that operates as a separate company. The net effect is to allow the “good” portion of the bank to operate unencumbered by the “bad” bank’s problems. A liquidation plan is prepared for each asset in the bad bank, and the asset values are discounted to current value. Investors buy the securitized “bad” debt, betting that the proceeds of the liquidation will be sufficient to repay the debt on time ...9 The primary advantage of the good bank/bad bank structure is that the old bad bank assets are dealt with separately from the good bank assets. It is far easier for a good bank to succeed when it is unencumbered by the bad bank’s assets because the good bank has a lower cost of capital. Thus, under the good bank/bad bank structure the good bank enjoys a better comparative advantage. Early in the history of the deployment of the good bank/bad bank model, a variety of alternative scenarios emerged through private ordering in the absence of regulatory intervention. These strategies emerged to provide flexibility in dealing with the twin challenges facing regulators and private-sector creditors who are trying to resolve a failed bank. These challenges are: (1) to deal with the troubled institution’s non-performing and under-performing (bad) assets; and (2) to avoid the costs and inefficiencies associated with maintaining bad loans in moderately healthy institutions. 8 U.S. Banking: Making the Good Bank/Bad Bank Structure Work, INT'L FIN. L. REV., April 1992, at 34. 9 Mayer, Slicing the Mellon: Behind the Good Bank/Bad Bank Scheme, BARRONS, Aug. 15, 1988, at 100; Restructuring the Healthy Bank, BANKERS MAGAZINE, Nov.–Dec. 1988, at 35. 10 In other words, the good bank/bad bank strategy can be employed with or without actual failure, and with or without the participation of the government. In fact, there is some indication that even regulators are beginning to realize benefits from shifting the management of failed institutions to the private market.10 Thus, a number of alternative scenarios for organizing the assets of insolvent and nearly insolvent banks have evolved. For example, a bank might spin-off its non-performing assets into a separate institution. Alternatively, a bank might be acquired and, following the acquisition, the low quality assets might be spun-off into a separate entity while retaining the acquired bank as the repository for the performing assets. Similarly, a bank might be acquired and split into two new institutions, each managing separate types of assets. It is worth noting that each of these alternatives is available in both the private market as well as under situations of public receivership. When the insuring agency takes control, it could choose to manage the assets of an insolvent institution separately, or consolidate those bad assets in one entity, such as the use of the asset management corporation Securum in Sweden, or the use of the Resolution Trust Company (RTC) in the United States. While the U.S. RTC was a wholly governmental entity, it is probably more accurate to view Sweden’s Securum as quasi-private, quasi-public entity. Securum was established in 1992 to manage the bad assets of Nordbanken. Securum took over troubled assets with an original book value of SEK 67 billion, consisting of SEK 60 billion in loans and SEK 7 billion in real estate and other tangible assets. These assets were acquired for SEK 50 billion (having been written down by SEK 17 billion by Nordbanken prior to their transfer to Securum). Securum itself was financed with loans from Nordbanken of SEK 27 billion, and an equity infusion of SEK 24 billion from the state of Sweden. As with other bad banks, Securum’s mission was to manage and, ultimately, liquidate Nordbanken’s assets, recovering as much as possible from debtors, and minimizing the total costs to the State and taxpayers.11 10 INT'L FIN. L. REV., supra note 8, at 34 (indicating a trend toward a preference for the private market for the management of troubled assets retained by the government). 11 Securum AB, 1992–1997 (English Version) at 2. 11 4. A Brief History of the Good Bank/Bad Bank Strategy This good bank/bad bank restructuring strategy first emerged on a large-scale in the mid- 1980s in the United States. In 1985, the FSLIC first used the strategy to deal with Westside Federal Savings and Loan of Seattle. The FSLIC created a good bank called Mariner Federal Savings and Loan, an entity later acquired at a substantial premium. At the end of 1986, the FSLIC had employed this restructuring strategy with at least ten additional institutions. Already in 1984, the FDIC bailed out Continental Illinois Corporation. The FDIC's Continental bail-out plan, however, resembles a good bank/bad bank structure, as the FDIC acquired $3.5 billion in bad loans and began to try to manage these loans by either selling or collecting on them.12 In essence, Continental's non-performing assets were placed in a governmental version of a bad bank. The 1986 acquisition of Texas Commerce Bancshares by Chemical New York Corporation is another example of a deal that included the creation of a separate entity to house the acquired bank's troubled loans.13 The Chemical acquisition was facilitated by a measure of regulatory flexibility in obtaining the necessary capital requirements to receive approval for the acquisition.14 The Chemical transaction illustrates the various means by which the merger can be facilitated, such as offering an unleveraged pool of non-performing assets as consideration.15 Also, in 1986, Midland Banks established a separate entity to deal 12 Rose, supra note 7, at 43. 13 Phillip L. Zweig & Steven Frazier, Chemical to Buy Houston Bank for $1.19 Billion, WALL ST. J., Dec. 16, 1986 (describing acquisition of Texas Commerce Bancshares by Chemical New York Corporation and the creation of a separate entity to hold a portion of Texas Commerce's nonperforming loans). 14 “[R]egulators may be willing to accept commitments to restore capital promptly following the completion of a good bank/bad bank spin-off.” INT'L FIN. L. REV., supra note 8 at 34 (citing the Chemical/MHT transaction as evidence of regulatory willingness to allow flexibility for achieving capital requirements following a restructuring). But, “they have far from embraced the structure ... [and] the Federal Reserve has shown that it will closely scrutinize any proposed transaction” and should the bad bank take the form of a trust, partnership or corporation, the SEC will also place the entity under close scrutiny given the implications the institution will have for the Investment Company Act. Id. 15 Edward Herlihy et al., Financial Institutions—Mergers and Acquisitions 1996: Another Successful Round of Consolidation and Capital Management, Corporate Law and Practice Course Handbook Series, PLI Order No. B4-7179, Feb. 1997, at 386 n.6 (strategy utilized by 12 with the troubled loans of its Crocker National Corporation, facilitating the sale of Crocker to Wells Fargo.16 In connection with its 1988 recapitalization, Mellon Bank Corporation implemented a very successful good bank/bad bank restructuring strategy. The Mellon strategy is often cited as an important example of this concept. The Mellon strategy took the form of a liquidating bank structure. Grant Street National Bank was chartered, taking the form of a limited- purpose bank structure under voluntary liquidation pursuant to the National Bank Act. Grant Street became the bad bank and was under jurisdiction and supervision of the Office of the Comptroller of the Currency throughout the liquidation process.17 The Mellon deal cost $166 million and absorbed $142 million in losses from the sale of non-performing assets to the bad bank.18 The deal was financed through a sale of $513 million in junk bonds and other debt by Drexel Burnham Lambert, Inc.19 The new bank was further capitalized by a $128 million contribution by Mellon itself.20 The good bank/bad bank strategy continues to be utilized in the United States. For example, a number of bank holding companies (most notably BankAmerica and First Chicago) began probing the possibility of using bad bank securitization strategies for troubled Chemical in its 1987 acquisition of Texas Commerce Bancshares and First Interstate in its 1988 acquisition of Allied Bancshares). 16 C. Thomas Long & Jamie P. Bowman, Regulation of Savings and Loan Associations and Saving and Loan Holding Companies and Related Issues, Corporate Law and Practice Course Handbook Series, PLI Order No. B4-6872, Apr. 27, 1989, at 221-23. 17 ”Grant Street was subject to various regulatory restrictions, including lending limits and restrictions on holding foreclosed properties for longer than five years. Since Grant Street did not accept deposits, did not grant credit to the public in the ordinary course of its business and was not insured by the FDIC, it was not deemed to be a bank for Bank Holding Company Act purposes. It did qualify as a bank, however, for Investment Company Act purposes, thus exempting the activities of Grant Street from the provisions of that statute.” Herlihy et al., supra note 15 at 393. 18 Stephen Kleege, Mellon Inspires ‘Bad Bank’ Plans for Property Portfolios, AM. BANKER, Feb. 5, 1991, at 6. 19 Id. 20 Id. 13 real estate assets as early as 1992. Permutations of the good bank/bad bank strategy have also surfaced where a full-fledged restructuring is too difficult or expensive. Since the initial innovation of the good bank/bad bank restructuring scheme in the banking industry, other industries have borrowed the concept of spinning off bad assets and liabilities, including the real estate industry,21 the insurance industry,22 and even construction firms.23 21 Kleege, supra note 18, at 6; Lynn B. Sagalyn, Conflicts of Interest in the Structure of REITS, REAL ESTATE FINANCE, Summer 1996, at 34 (describing the use of a good bank/bad bank format in real estate); Adrienne Linsenmeyer, Solving the Real Estate Crisis, FINANCIAL WORLD, Mar. 19, 1991 (describing the high frequency of proposals to solve problems in the real estate market with a good bank/bad bank concept); Stan Ross & Dennis Yeskey, Real Estate Relief, BEST'S REV. - PROPERTY-CASUALTY INS. ED., Jan. 1993, at 31 (discussing option for life insurance companies to use the strategy to confront non-performing real estate loans and real estate owned). 22 Ruth Gastel, Insolvencies/Guaranty Funds, III INSURANCE ISSUES UPDATE, Dec. 1997 (describing the National Association of Insurance Commissioners' white paper and standards for good bank/bad bank restructuring models in the insurance industry); A.M. Best Reviews Emerging Insurer ‘Good Bank/Bad Bank’ Structures, Discusses Its Role and Rating Implications, PR NEWSWIRE, Dec. 27, 1995 (describing the increasing use of the strategy in the insurance industry); CIGNA Good Bank/Band Bank Debate Rages, BESTWIRE, Dec. 18, 1995 (discussing the arguments for and against the CIGNA good bank/bad bank plan); Shifting Insurance Liabilities: A Risk to Policy-Holders?, CORP. LEGAL TIMES, Aug. 1996, at 46 (roundtable discussion, including discussion of the good bank/bad bank model in the insurance industry); Ernst & Young, Who's Afraid of Environmental Liability?, MONDAQ BUS. BRIEFING, June 18, 1996 (describing insurance restructurings using the good bank/bad bank strategy); Jan H. Schut, Lloyd's Last Chance, INSTITUTIONAL INVESTOR, May 1996, at 113 (describing the reinsurance strategy of Lloyd's of London to runoff liabilities to Equitas); Robert Stowe England, At the Brink, FINANCIAL WORLD, Nov. 21, 1995, at 70 (same); Lloyd's of London: Solvent Abuse, ECONOMIST, Apr. 29, 1995, at 88 (same); Jan H. Schut, The Emilco Enigma, INSTITUTIONAL INVESTOR, Mar. 1996, at 37 (describing insurer Emilco's restructuring plan); John H. Snyder et al., The Industry at a Turning Point, BEST'S REV. - PROPERTY, CASUALTY INS. ED., Jan. 1996, at 36 (insurance industry); Dave Lenckus, CIGNA Critics Unmoved Despite Best Defense, BUS. INS., Jan. 1, 1996, at 1 (describing CIGNA's restructuring plan loosely modeled on the good bank/bad bank strategy); Mary Jane Auer, Spinning Off Liabilities Into a Separate Company May Bring More Pain than Gain, INSTITUTIONAL INVESTOR, Nov. 1997, at 43 (criticizing the good bank/bad bank model for dealing with insurance company liabilities, especially as used to deal with asbestos and environmental liabilities). 23 Brad German, Paradise Lost: California Builders Suffer Losses, BUILDER, May 1993, at 78 (describing the initial trial of the strategy in the construction industry). 14 The good bank/bad bank strategy has been suggested or employed for banks in numerous countries facing banking crises, including France,24 Germany,25 the Czech and Slovak Republics,26 Thailand,27 China,28 New Zealand,29 and Brazil.30 Japan, with its 24 Howard C. Gelbtuch & Takashi Kataoka, Real Estate Securitization Gaining Favor in France and Japan, REAL ESTATE ISSUES, Aug. 1997, at 1 (“In France ... many banks began setting up ‘good bank’/‘bad bank’ structures ... [E]quity investors have generally reacted favorably to the French restructurings, pushing up share prices as problem real estate is removed from a company's books.”); Brussels Irked by French Evasions Over Bank Rescue: Taxpayers May Have to Dig Deep to Sort Out Credit Lyonnais, FIN. TIMES (London), Nov. 26, 1997, at 2 (discussing the separation of Credit Lyonnais's assets by stripping the non- performing ones into a bad bank called the Consortium de Realisation, and the French finance minister's call to have the good bank scrutinized differently than the bad bank). 25 David Shirreff, The Ultimate Stress-Test, EUROMONEY, Sept. 1997, at 117 (describing a consortium of big German banks securing a good bank/bad bank split to deal with the Bayerische Kreditbank (BKB) problem). 26 Good Bank, Bad Bank, EAST EUROPEAN INS. REP., Apr. 1997 (describing the Czech National Bank's splitting of Agrobanka into solvent and insolvent parts); Michael S. Borish et al., Banking Reform in Transition Economies, FINANCE & DEVELOPMENT, Sept. 1995, at 23 (describing the good bank/bad bank approach of the Czech and Slovak Republics to recover non-performing loans as “feasible when governments are committed to fiscal prudence, rapid bank privatization, and changes in bank management and governance.”). 27 Siriporn Chanjindamanee, Tarrin to Seek Cabinet Nod for “Good Bank,” World Sources Online, Inc., Emerging Markets Datafile, Jan. 13, 1998 (discussing Thailand's official financial sector restructuring plan based on the Swedish good bank/bad bank model); Technically Insolvent Thai Finance Firms Propose Joint Rehabilitation, AGENCE FRANCE PRESS, Oct. 30, 1997 (describing proposal by 58 suspended finance firms to establish a good bank/bad bank structure where the good assets would be grouped under license of Chatphaibul Finance and the bad debts would be bought up at a large discount by Asset Management Corp.). 28 Gordon G. Chang, China, INT'L FIN. L. REV., July 1997, at 21 (describing $600 billion in non-performing bank loans in China and the framework for a solution based on the good bank/bad bank structure, yet also illustrating Beijing's unwillingness to adequately fund the plans). 29 In 1990, the Bank of New Zealand (BNZ) established, with limited success, a bad bank, Adbro, while BNZ became a good bank. Terry Hall, Public Outcry Fails to Fend Off Bid for BNZ—The Pain Caused by Australia’s Takeover of a Neighbor’s Financial Icon, FIN. TIMES (London), Nov. 6, 1992, at 30. 30 Jim Freer, Slow Adjustment: Brazil's Economic Policy, LATIN FIN., Dec. 1995, at 40 (anticipating use of the strategy in Brazil). 15 financial crisis partially motivated by non-performing bank assets, is just beginning to consider the strategy and its potential within Japan's unique syndicate structure and critical financial situation.31 Perhaps the most well known good bank/bad bank strategy, however, was developed in Sweden and launched there in 1992.32 As of 1995, costs and work force had been cut by 20 percent and Nordbanken had become Sweden's most profitable bank.33 With pounds 4.5 billion in bad debts, the Swedish government instituted a pounds 4 billion bailout. As of 1995, of that amount, the government was expected to recoup pounds 2 billion through proceeds, taxes, and a special dividend.34 In all, good bank/bad bank restructuring provides a unique means for disposing of non-performing loans and returning an institution to health. One scholar has summarized some of the benefits of the strategy: The good bank-bad bank structure conveys three important benefits to the banks and thrifts that use it: (1) It immediately improves the bank's earnings power by improving the ratio of earning assets to costing liabilities and lowering its operating expense ratio (2) It immediately enhances the bank's ability to raise capital from external sources at reasonable cost, by improving the bank's earnings power and reducing the level of 31 Jeanne B. Pinder, Headache for Japanese Investors, N.Y. TIMES, June 2, 1993, at D1 (Japanese banks “large-scale, syndicated variation of the ‘good bank, bad bank’ strategy” to deal with problem real estate investments). But see Kenichi Ohmae, Five Strong Signals of Japan's Coming Crash, WASH. POST, June 28, 1998, at C1 (discussing the difficulty of isolating losses given the syndicate structures normally followed by Japanese banks and advocating that Japan adopt the Swedish model of creating an institution to facilitate the successful separation of the good assets from the bad); Is the Asian Flu Fatal? Asian Economic Crisis, REASON, May 1998, at 18 (Brookings Institution economist Robert Litan arguing that in Japan, “if they decided to take the good bank/bad bank approach, as a practical matter there are very few people or institutions in Japan that are healthy enough to buy the unhealthy stuff.”). 32 Mary Brasier, Swedish Bank Massage, DAILY TELEGRAPH, Oct. 13, 1995, at 25. 33 Id. 34 Id. 16 nonperforming assets; [and] (3) It allows the bank to play offense again. A high level of nonperforming assets has enervating effects on a bank's ability to compete aggressively and plan for the future. A return to competitiveness my be the most important benefit that the good bank-bad bank structure conveys.35 5. Hurdles to the Implementation of the Good Bank/Bad Bank Strategy: Securum’s Advantages Several incentives drive the use of the good bank/bad bank strategy. Regulatory agencies have an incentive to use the strategy when the losses to depositors or the government can be decreased. Private entities have an incentive to increase returns (i.e., avoid losses) on troubled assets through the benefits of separating the management of the assets. Private acquirors have an incentive to realize the profits available from restructuring underperforming banking firms. Additionally, in many countries, the tax advantages of spinning off bad assets provides another incentive.36 A remaining good bank is interested in obtaining the benefits of the tax code resulting from the spin-off, i.e. to record on its own books the loss inherent in the assets transferred to the bad bank. Despite these incentives, there are a number of significant hurdles to implementing a good bank/bad bank strategy. In particular, the transaction costs—such as legal and underwriting fees—associated with establishing and operating a good bank/bad bank structure may be high.37 Moreover, particularly where early intervention is being attempted by the regulatory authorities, there may be considerable disagreement over which assets are bad and which are good. However, in the case of Securum, the problem was not so much that intervention came late (which is the typical problem that has plagued other countries that have been faced with banking crises, including the U.S. and Japan), but that the crisis was exaggerated. The available evidence suggests that there was overreaction and panic in the 35 Hurley, supra note 7, at 4. 36 Long & Bowman, supra note 16, at 221–23 (describing the potential tax benefits of restructuring pursuant to the good bank/bad bank structure). 37 Rose, supra note 7, at 47. 17 face of what were, in reality, temporary liquidity problems within the Swedish banking industry. This atmosphere of crisis and panic made Securum’s job easier by creating a climate in which it was possible to under-state the value of the assets being transferred to Securum. By the time Securum was organized to accept the assets of Nordbanken, the prevailing view was that Nordbanken was in acute financial distress and there was a clear consensus that the majority of the loans taken by Securum were in default.38 The bad bank strategy is easy to implement when late intervention occurs because the assets taken by the bad bank are relatively easy to evaluate. In the case of Securum, the bad bank strategy was similarly easy to effectuate, albeit for a different reason: the atmosphere of crisis and panic surrounding the Swedish banking crisis made it possible for Securum to aggressively write-off the value of the loans it was assuming. This made Securum’s job of resolving these assets a more attainable task. Still another problem with establishing a successful bad bank is finding the appropriate personnel. As the discussion below makes clear, one of the principle strategic advantages to employing a bad bank strategy is that the human capital skills necessary to manage and resolve the problems associated with troubled assets are entirely different than the human capital skills that bankers must possess to deal with performing loans. A principle justification for utilizing a good bank/bad bank strategy is to move bad assets into institutional structures where qualified people who specialized in managing bad assets can deploy their skills. However, for this strategy to succeed, it must be possible to recruit people with appropriate industry-specific asset management skills to manage the bad assets. Indeed, this was one of the principle justifications for Securum: One of the basic ideas when Securum was created was that it would need a different type of expertise than a bank if it were to enhance the value of assets in real estate, industrial companies and hotels. Securum recruited qualified personnel with industry-specific know-how to the various asset management companies and their boards of directors. Securum then 38 Securum AB 1992–1997 supra note 11, at 13. 18 supported them as an active owner.39 Of course, finding such qualified, specialized personnel to work in a bad bank is not easy, and in some cases it is impossible. The problem of attracting and recruiting suitable personnel is particularly acute for bad banks because these institutions, when they are successful, will convert bad bank assets into cash expeditiously and efficiently. This means that successful bad banks will be dismantled relatively quickly. Indeed, one of the measures (although by no means the only measure) of a successful bad bank is how quickly it is able to convert non- performing loans into cash so that it can be dismantled. This, of course, adds to the difficulty of finding adequate personnel for bad banks. And, where appropriate personnel cannot be found, it is by no means clear that a good bank/bad bank strategy will be successful. Another obstacle to implementing bad bank strategies is the administrative and technical hurdles to evaluating the assets that come into a bad bank. In this regard, Securum had several advantages from the beginning that many bad banks do not enjoy. First, all of Securum’s assets came from the same place, Nordbanken. This meant that, unlike bad bank structures that accept assets from several troubled financial institutions, Securum was not forced to cope with the burdens of rationalizing and coordinating a variety of computer systems, filing systems, and information retrieval systems. Moreover, the documents that Securum had to work with were more uniform than they would have been if they had come from a variety of sources. This relieved the burden on the Securum personnel charged with evaluating loan documentation. In addition, because all of Securum’s assets came from a single source, it was possible for Securum to pattern its organizational structure after that of Nordbanken’s. Securum did this by adapting both its finance company’s organization and its real estate operations to Nordbanken’s regional structure. For other assets, Securum established an organization with one unit to deal with both hotels and tourism, and one unit to deal with industrial operations. By adopting an organizational structure that mirrored Nordbanken’s, Securum was able to achieve “speed and flexibility” in the disposition of assets.40 39 Id. at 15. 40 Id. at 25. 19 Another key advantage to having a bad bank dedicated to receiving the bad assets from a single firm (Nordbanken) relates to the need to recruit qualified, knowledgeable personnel. Securum recruited key personnel from Nordbanken. These people were not only available, of course, but they also had both general expertise in dealing with problem loans, as well as particularized knowledge of the particular assets coming into Securum. Of course, it will not be possible to recruit individuals who are as familiar with the bad asset portfolio when the bad bank must accept assets from a variety of financial institutions. Again in this context it is important to realize that late intervention makes it easier for the bad bank to achieve its objectives. The potential problem with having a bad bank recruit personnel from the troubled financial institution whose assets it is accepting is that some of these personnel may have been involved in the original decision to grant the non-performing loans that now constitute the assets of the bad bank. Where this occurs, potential conflicts of interest arise since the personnel involved in the original decision to grant the loan may be unwilling to recognize a problem or otherwise take responsibility for an earlier error. In the case of Nordbanken and Securum this problem was reduced because most of the loans taken by Securum were already in default. Consequently, the Nordbanken personnel hired by Securum generally were not the people who had granted the loans, but rather the personnel who administered the loans. These people not only did not have the same conflicts of interest as the people who had granted the loans, but also they had developed some particularized expertise in resolving troubled loans. Even in this situation, however, it appears that personnel problems arose within Securum, and that dealing with these problems often was “costly from a financial standpoint.”41 Still another special advantage that Securum enjoyed is an advantage that will not be available to every bad bank. In particular, this advantage may not be available to bad banks in developing economies. This advantage is that Securum only accepted assets above a certain minimum size, SEK 15 million. Securum took over loans to just over 400 borrowers (3,000 loan commitments altogether). Securum’s task of resolving these troubled loans was made easier to the extent that it is easier to administer a relatively small number of large loans than to administer a large number of small loans. 41 Id. at 29. 20 Thus, while it is undoubtedly true that it is better to remove bad assets from problem banks than to leave them within such banks, it is important to recognize: (1) the bad bank structure is not cost-free; (2) the bad bank structure is not the only mechanism for accomplishing the objective of removing bad assets from problem banks; and (3) in certain contexts, notably that of Securum, the bad bank arrangement may work better than in other contexts. The problems of implementing a successful bad bank strategy have led several financial institutions to opt for less complex solutions to cope with their troubled loan problems. These alternatives include individual asset sales, bulk sales to private investors (Chemical bank), bulk sales through public or private auctions (as with California Federal and Glendale), and other aggressive disposition and work-out strategies.42 One of the most formidable barriers to a good bank/bad bank organizational structure involves capital acquisition, including the demands by regulatory authorities that the bad banks (and good banks) raise more equity capital in order to meet capital requirements for continuing operations.43 Modern capital adequacy regulations serve to impede good bank/bad bank projects. When troubled assets are separated and “marked to market on transfer to an unconsolidated entity,” or when the bad bank's equity is dispersed to shareholders, capital will be reduced. Restoration of this capital may be required in order to receive approval from regulators. For example, in the case of the Mellon Bank transaction, $200 million in new equity securities were sold concurrent with its announcement of its bad bank plan. Financing for the Mellon strategy and its collecting bank, Grant Street, largely resulted from use of the junk bond market. The decline of this market makes the private financing of bad bank strategies much more difficult.44 Some of this difficulty is the result of regulators unwillingness to approve certain types of financing structures necessary to implement the strategy.45 42 Herlihy et al., supra note 15, at 425 (strategy utilized by Chemical in its 1987 acquisition of Texas Commerce Bancshares and First Interstate in its 1988 acquisition of Allied Bancshares). 43 Rose, supra note 7, at 47. 44 Herlihy et al., supra note 15, at 388. 45 Id. Herlihy et al. explain this type of impediment in relation to Premier Bancorp and the possibilities for future financing strategies: 21 Given the difficult regulatory hurdles, as well as the logistical aspects of planning, applying and financing the project, the process of implementing a good bank/bad bank restructuring will be at best lengthy, and in all likelihood impossible without the active support of the government.46 The next sections review in somewhat greater detail the principal economic advantages of the good bank/bad bank strategy. Determining what economic principles motivate the attraction of the good bank/bad bank strategy is critical to understanding its utility. 6. Specialization Many advocates of the good bank/bad bank strategy argue that the primary economic rationale behind the strategy involves the ability to jettison or dump non-performing assets, consequently freeing an institution of the albatross of bad loans and reaping the tax benefits of disposing of the bad assets at a loss. While this is undoubtedly true, it is a simplistic characterization of the possibilities available in asset management following a good bank/bad bank restructuring. It assumes that the performing loans will exhibit no net increase above their market value at the time of restructuring. In other words, this explanation focuses too much on the advantages to the good bank, and not enough on the advantages to the bad bank. In early 1990, Premier Bancorp abandoned its plans to spin off a collecting bank because of its inability to obtain the necessary mezzanine financing. Federal regulators had ruled that it would be unacceptable for Premier's main subsidiary bank to provide partial mezzanine financing for the collecting bank, and Premier was unable to obtain the needed financing from unaffiliated investors. Over time, third-party mezzanine financing may once again be available for good bank/bad bank structures. Even with improved market conditions, difficulties in financing good bank/bad bank structures are likely to persist. Despite improvements in the market for mezzanine financing, it may be difficult to finance a special asset company at full asset value levels. Structures involving larger equity components (possibly to be provided by existing shareholders) and/or risk sharing formulas may be required. Id. 46 Id. (reporting that it can take up to a year, during which market conditions could change to the detriment of the strategy). 22 Moreover, this explanation relies too much on the artificial profit associated with the tax advantages of restructuring. As suggested above, a better rationale for adopting a good bank/bad bank strategy is that such a strategy permits both the owners of the good assets and the owners of the bad assets to reap the benefits of specialized management in order to maximize the returns on each type of asset. Alternatively, when the assets are grouped together, management must constantly face conflict over the application of scarce firm resources to each. As discussed in the next section, the market’s ability to identify the quality of assets is often low. Thus, non-performing assets may drag the good assets down as investors are unable to delineate between the two, subsequently decreasing the value of both. When good and bad assets are managed together, they act as rivals. George Stigler has described the inefficiencies that result from a firm’s management of rival functions.47 He describes these rival functions as those for which ”the greater the rate of output of one process, the higher the cost of a given rate of output of the other process.”48 Given finite resources, the processes within a firm will always compete. For example, this problem arises “when the entrepreneur must neglect production in order to supervise marketing.”49 A manager of a firm with large number of assets in both performing and non- performing categories must necessarily neglect production of one to serve the other. It is merely an application of the economic concept of opportunity costs. This rivalry occurs in banking institutions with significant holdings of both good and bad assets. As Crockett explains, eliminating this conflict can increase the performance of all assets involved: Separating the workout and disposition of low-quality assets from the healthy institution also eliminates the potentially adverse effects of having both performing and nonperforming assets managed by the same institution. For example, an 47 See George J. Stigler, The Division of Labor is Limited by the Extent of the Market, 59 J. POL. ECON. 185, 185, 187, 185–93 (1951), reprinted in GEORGE J. STIGLER, THE ORGANIZATION OF INDUSTRY 12, 129–41 (1968). 48 See Stigler, reprinted in TIM JENKINSON, READINGS IN MICROECONOMICS, at 144 (1996) 49 Id. at 142. 23 aggressive collection program or a policy with strict limits on forbearance toward troubled borrowers may be consistent with maximizing the realization values of distressed loans and assets. Having a separate entity pursue this policy eliminates any potentially ill effects on the institution's reputation with prospective borrowers. Similarly, separate organizations make it possible to follow an optimal asset disposition policy independent of any concern about the effects of such a policy on the financial results that would be reported by a single firm.50 Thus, the task is to find a means by which rival processes can each see a net increase in production without necessarily expending additional resources. This is precisely the economic basis underlying the market’s tendency toward specialization. Remove the rivals, separate the assets, and focus the attention on the particularized managerial task. Thus, specialization not only works because persons are able to concentrate their energy on one task, but also because marketplace incentives prompt people to concentrate in areas where they hold (or can develop) a particularized skill. This process leads to the more efficient allocation of human resources and brings the concomitant increase in efficiency in the efforts of those resources.51 In contrast to the separation of good and bad assets in Securum, take the case of Swenska Handelsbanken. In Handelsbanken, the good and bad assets were not segregated and the responsibility for existing assets remained with the old managers, who aggressively fought for recognition of losses. Consistent with the Securum experience, it is the economics of specialization that provides the strongest justification for the good bank/bad bank strategy. 50 John H. Crockett, The Good Bank/Bad Bank Restructuring of Financial Institutions, BANKERS MAGAZINE, Nov.–Dec. 1988, at 34. 51 Geoffrey C. Hazard, Jr., “Practice” in Law and Other Professions, 39 ARIZ. L. REV. 387, 396 (1997) (“Specialization of knowledge and technique has so many benefits for society as a whole that it is an irreversible process, at least short of an atomic or astrophysical catastrophe that returns us all to being cave people.”). 24 By dividing asset responsibility between the banks, each is capable of capturing the specific skills necessary for managing distinct categories of asset quality because the management of bad assets requires different skills than the management of good assets.52 According to this “axiomatic” principle,53 it is the productive advantages of skill specialization that drive the division of labor.54 Thus, performance is inversely proportional to the number of multi-skill tasks undertaken by a single individual.55 Similarly, the return on the expenditure of human capital resources is increased when those resources are directed to a specific skill. This is what Adam Smith describes as the division of labor improving the “dexterity of the workman.”56 Superior knowledge, training, and experience in a specific field makes one better at his job. Thus, managers able to specialize following a restructuring will not only direct their skills to managing a distinct category of assets, but their skills in that process should also improve, assuming they were required previously to develop skill in handling both bad assets and good assets. In other 52 Crockett, supra note 50, at 34. 53 Hazard, supra note 51, at 390 (describing Smith's theory of specialization as “axiomatic”). 54 ADAM SMITH, WEALTH OF NATIONS 11 (Kathryn Sutherland ed., 1993). Smith articulates the principle that the division of labor, causing skill specialization, increases productivity: “The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seem to have been the effects of the division of labour.” Id. 55 Adam Smith articulates the relationship: The division of labour, however, so far as it can be introduced, occasions, in every art, a proportional increase of the productive powers of labour. The separation of different trades and employments from one another, seems to have taken place, in consequence of this advantage. This separation too is generally carried furthest in those countries which enjoy the highest degree of industry and improvement. Id. at 13. 56 Id. at 15. Smith describes the impact: First, the improvement of the dexterity of the workman necessarily increases the quantity of the work he can perform, and the division of labour, by reducing every man's business to some one simple operation, and by making this operation the sole employment of his life, necessarily increases very much the dexterity of the workman. Id. 25 words, quality will increase. The quantity of work also increases from specialization. This advantage results from savings in time related to specialization. A concentration of resources upon completion of a distinct task over time increases the speed by which that task can be accomplished effectively.57 Furthermore, no time need be used inefficiently (or wasted) dealing with the difficult loans spun-off to the bad bank at the good bank.58 Specialists also are far more likely to discover innovations unique to their task. As Adam Smith explains: [T]he invention of all those machines by which labour is so much facilitated and abridged, seems to have been originally owing to the division of labour. Men are much more likely to discover easier and readier methods of attaining any object, when the whole attention of their minds is directed towards that single object, than when it is dissipated among a great variety of things. But in consequence of the division of labour, the whole of every man's attention comes naturally to be directed towards some one very simple object. It is naturally to be expected, therefore, that some one or other of those who are employed in each particular branch of labour should soon find out easier and readier methods of performing their own particular work, wherever the nature of it admits of such improvement.59 This effect is especially important in the productivity of bad banks. Managers are faced with 57 Id. at 16 (“Secondly, the advantage which is gained by saving the time commonly lost in passing from one sort of work to another, is much greater than we should at first view be apt to imagine it.”). 58 Rose, supra note 7, at 44 (“It can reduce the operating expenses, especially management and staff time, of the ‘good’ bank that sold its troubled loans. The time spent working out problem loans can now be devoted more profitably to other staffing needs.”). 59 ADAM SMITH, supra note 54, at 17. 26 currently non-performing assets and must turn them around. After restructuring, not only can managers bring the special skills needed for managing these types of bad assets, the theory of specialization predicts that their focus on this distinct managerial task allows for the invention of innovative profit-maximizing techniques.60 When dealing with bad assets, innovation is deeply needed. When those assets remain consolidated with good assets, however, the bad assets are not as likely to get the necessary attention required to discover new ways to realize profit from these assets. The banking industry in particular has long recognized the benefits of specialization in lending and other banking functions. For example: Securitization also permitted an uncoupling of the component functions served by banks and thrifts as financial intermediaries, allowing for specialization by institutions with comparative advantages in one or more of these functions. For example, many banks and thrifts chose to focus more on the origination function of lending and less on the funding function by securitizing the loans they originated, thus enabling them to expand loan volume faster than deposit growth. At the same time, the risks inherent in the traditional intermediary functions of banks and thrifts that became more pronounced as a result of volatile interest rates in the 1970s and 1980s, such as prepayment risk and interest rate risk, could be better managed 60 Rose, supra note 7, at 44. Rose argues: [T]he management of the ‘bad’ banks can specialize in collecting whatever value remains in its newly inherited portfolio of problem loans. This kind of specialization can cut operating expenses and avoid destroying community goodwill for the ‘good’ bank, because it no longer has to hound hundreds of customers about repaying their loans. Id. 27 through asset securitization, which essentially provides a direct match between the asset and the provider of capital.61 This matching process is correlated with both the specialized institution and the consequent increase in the ability to price assets in the market once they are separated according to performance value. The good bank/bad bank structure separates two distinct types of assets,62 placing them under separate management authority. According to Bengt Dennis, ex-governor of Sweden's central bank, the good bank/bad bank model “helps focus management resources on 61 Joseph C. Shenker & Anthony J. Colletta, Asset Securitization: Evolution, Current Issues and New Frontiers, 69 TEX. L. REV. 1369 (1991) (citing E. CORRIGAN, FINANCIAL MARKET STRUCTURE: A LONGER VIEW 28 (1987)) (extension of securitization process in unbundling of credit intermediation into multiple discrete pieces, presumably reflecting benefits of specialization); J. HENDERSON & J. SCOTT, SECURITIZATION 6 (1988) (noting that “securitization may allow and encourage firms to specialize in that part of the loan-making process where they can exploit their competitive advantage as a possible low-cost producer of their particular portion of the loan-making chain”); J. ROSENTHAL & J. OCAMPO, SECURITIZATION OF CREDIT 14, 227–28 (1988) (explaining that securitization breaks the vertically integrated process of lending into discrete series of steps and permits firms to focus on a limited number of roles in the process to build a competitive advantage); GREENBAUM & THAKOR, Bank Funding Modes: Securitization Versus Deposits, 11 J. BANKING & FIN. 379 (1987) (noting that securitization decomposes traditional lending process into more elemental activities, thereby permitting intermediaries to specialize in those more basic activities in which they enjoy a comparative advantage)). See also Naomi R. Lamoreaux, Information Problems and Banks' Specialization in Short-Term Commercial Lending: New England in the Nineteenth Century, in INSIDE THE BUSINESS ENTERPRISE: HISTORICAL PERSPECTIVES ON THE USE OF INFORMATION 161, 180 (Peter Temin ed., 1991). 62 John H. Crockett, supra note 50, at 32. One source of gain is in economies from management specialization. Managing a portfolio of distressed assets is a different activity from managing a solvent thrift institution. Splitting a failed institution into two components may reduce the demands on higher level managers who would otherwise be faced with information gathering and decision making in each of the divisions. To the extent that this streamlining results in more timely decisions and lowered costs of managerial coordination, cash flow benefits will materialize. Id. at 34 (emphasis added). See also JOHN H. CROCKETT, ON THE GOOD BANK/BAD BANK RESTRUCTURING OF FAILED THRIFTS (1987). 28 two distinct and separate functions.”63 It allows an institution to bring special management to assets with special needs. Furthermore, management can perform better when it has a strategy focused on particular assets.64 The management of the good bank no longer needs to struggle with the non-performing assets. The management of the bad bank can accept their limitations, but also, facing the challenge, know that their successful efforts will be identifiable and can be rewarded. Their objective is more apparent and greater certainty in the duration of their institution's survival also diminishes the indifference or nervousness that can impede effective management.65 Also, managers and investors can better appraise the value of the assets under their control and, consequently, can provide more accurate information to the market.66 Additionally, excessive risk taking and other forms of moral hazard, which often cause troubles for a banking institution can be curtailed through the use of a good bank/bad bank strategy. The separation of assets into identifiable performance categories permits more effective monitoring of managerial performance.67 This should give managers a greater incentive to manage effectively in order to maintain their positions.68 63 Confidence Seen as Key Factor Swede Outlines Way to End Crisis, NATION (Bangkok), Dec. 11, 1997. 64 Crockett, supra note 50, at 32–34. Crockett explains: Uncertainty ... is not conducive to managerial initiative. Unclear objectives and diffuse responsibility make it more difficult to summon managerial action that will maximize the value of the firm. To the extent that the restructuring approach avoids these disincentives, it may lead to increased cash flows over time. Id. at 34. 65 Id. (“Similarly, a well-defined objective and a finite horizon for workout specialists lead to more efficient management of bad assets.”). 66 Alchian, Information Costs, Pricing, and Resource Unemployment, 7 W. ECON. J. 109, 110 (1969) (“Like any other production activity, specialization in information is efficient. Gathering and disseminating information about goods or about oneself is in some circumstances more efficiently done while the good or person is ... able to specialize (i.e., while specializing) in the production of information.”). 67 Id. 68 Crockett, supra note 50, at 34. Crockett explains that managers will have more 29 7. The Communication of Information on Asset Quality An additional economic justification for the implementation of a good bank/bad bank strategy stems from investor reaction to the segregation of assets and management. First, investors can respond to the existence of separated management and the benefits that accrue from that specialization. Second, as discussed earlier in this part, monitoring is less difficult when assets are separated. The basis for such enhanced monitoring largely results from the increase in available information on the value of assets stemming from management targeted by performance level. Prior to restructuring, investment in both good assets and bad is hindered by the market's inability to identify the risks associated with investment. Akerlof describes this as the “lemons problem.”69 When investors cannot easily assess the quality of goods offered by sellers and sellers are assumed to have superior knowledge of such quality, inefficiencies result because market investors cannot trust that they are making an economically sound investment. They are averse to the risk that they may be investing in a lemon.70 Dishonest sellers have the ability to misrepresent the quality of goods (i.e., offer identifiable responsibilities over assets and that the performance of these assets can more effectively be evaluated: It is reasonable to expect that separate organizations will make the task of monitoring and evaluating managerial performance simpler. In turn, this will have favorable effects on the incentive structure for managers. ... By stabilizing the good bank, managers and employees will perceive the benefits from continuing routine activities such as loan origination and marketing to prevent the runoff of core deposits [as opposed to those managers who see themselves as mere temporary caretakers]. Id. 69 George A. Akerlof, The Market for “Lemons”: Quality and the Market Mechanism, 84 Q.J. ECON. 488–500 (1970). 70 Id. While this is an expected response of a rational economic actor, some scholarship in cognitive psychology identifies additional factors that may motivate this result. Carol M. Rose, Giving Some Back—A Reprise, 44 FLA. L. REV. 365, 374 n. 57 (1992) (citing Roger G. Noll & James E. Krier, Some Implications of Cognitive Psychology for Risk Regulation, 19 J. LEGAL STUD. 747, 752, 776–77 (1990) (suggesting that people are generally risk averse, where “intuitive risk perception weighs potential losses more heavily than potential gains (‘loss aversion’)”). 30 “lemons”) in a market plagued by large information disparities. These sellers can act opportunistically, preying on those with inferior information.71 The inability of buyers to distinguish between honest and dishonest sellers also decreases the confidence investors will have in making an investment. Problems in both identifying asset value and monitoring lead to decreased prices. Because such a decrease affects honest and dishonest sellers alike, the honest sellers will no longer find it profitable to remain in that market,72 depressing prices even further as the confidence in asset management decreases.73 Akerlof's theory of the effects of severe quality uncertainty is an extension of Gresham's Law which states that bad money tends to drive out good money in an economy where both are in use.74 This mis-allocation of resources results in deadweight social losses.75 A significant amount of scholarship has explored the application of the Akerlof lemons hypothesis in a variety of fields.76 71 Several articles provide examples illustrating that consumers without information, if they purchase at all, tend to purchase low-quality products at high quality prices, absent the ability to distinguish between them. See, e.g., Lucian A. Bebchuk, Litigation and Settlement Under Imperfect Information, 15 RAND J. ECON. 404 (1984); Gregg Jarrell & Sam Peltzman, The Impact of Product Recalls on the Wealth of Sellers, in EMPIRICAL APPROACHES TO CONSUMER PROTECTION ECONOMICS 377 (Pauline M. Ippolito & David T. Scheffman eds., 1986); Benjamin Klein & Keith B. Leffler, The Role of Market Forces in Assuring Contractual Performance, 89 J. POL. ECON. 615 (1981); Sam Peltzman, An Evaluation of Consumer Protection Legislation: The 1962 Drug Amendments, 81 J. POL. ECON. 1049 (1973); Carl Shapiro, Premiums for High Quality Products as Returns to Reputations, 98 Q. J. ECON. 659 (1983); Thomas S. Ulen, The Coasean Firm in Law and Economics, 18 J. CORP. L. 301 (1993). See also generally JACK HIRSHLEIFER & JOHN G. RILEY, THE ANALYTICS OF UNCERTAINTY AND INFORMATION (1992). 72 A similar analysis indicates that good managers will tend to leave troubled institutions as profits fall and their talents can yield greater salaries elsewhere. 73 See George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 Q.J. ECON. 488, 488–90 (1970). 74 See id. at 489. 75 Id. at 488. 76 See, e.g., T. Markus Funk & Daniel D. Polsby, Distributional Consequences of Expunging Juvenile Delinquency Records: The Problem of Lemons, 52 WASH. U. J. URB. & CONTEMP. L. 161 (1997); Walter Kamiat, Labor and Lemons: Efficient Norms in the Internal Labor Market and the Possible Failures of Individual Contracting, 144 U. PA. L. REV. 1953 (1996) 31 A good bank/bad bank restructuring alleviates the lemons problem facing many troubled financial institutions. The segregation of assets allows investors to more accurately verify the value of each bank's assets and better identify dishonest managers due to the decreased monitoring costs associated with the separation. Capital market investors will be less fearful that the good bank will fail.77 Additionally, when the bad bank becomes controlled by a specialized management team that will gain more accurate information about valuing and collecting loans, many investors will be willing to pay for that information, thereby raising the value of the bad bank's assets.78 And, perhaps most importantly, the fact that the bad bank management was not involved in the granting of the original troubled loans adds a large measure of credibility to the process. Where the managers of the bad bank are not associated with the original credit decision, it stands to reason that they are far more likely to recognize fully the nature and extent of the losses of the assets being held by the bad bank. There are two reasons for this. First, while the managers who originally made the loans may be reluctant for both economic and psychological reasons to write-off the bad loans on their banks’ books, new managers suffer no such perverse incentives. Once a loan decision has been made, an ample body of literature in social psychology shows that this earlier approval will strongly affect the later actions and decisions of the people who originally made and approved the loan. In particular, the “theory of escalating commitments predicts that banks’ officers will come to identify with the loans they have made, and that future decisions regarding those loans will be made so as to be consistent with the earlier decisions.”79 (applying Akerlof theory to explain the absence of “just cause” contracts in the non-union workplace); VICTOR P. GOLDBERG, READINGS IN THE ECONOMICS OF CONTRACT LAW 2 (Victor P. Goldberg ed., 1989) (noting that the economic term “[a]dverse selection now refers to any situation in which an individual has knowledge about his own quality (the goods he sells, his ability to perform, his health status) while whomever he is dealing with knows only about the characteristics of the average member of the group”); William Samuelson, Bargaining Under Asymmetric Information, 52 ECONOMETRICA 995 (1984) (examining behavior of buyers holding different degrees of information). 77 Rose, supra note 7, at 44. 78 Id. at 45. 79 T. Gilovich, “How We Know What Isn’t So: The Fallability of Human Reason in 32 From an economic perspective, bank managers also have incentives to decline to recognize the problems associated with loans they previously have made. Managers may abstain from writing down troubled loans they have made in order to preserve their reputations, their bonuses, and even their jobs. Obviously, taking corrective action to write- off a bad loan reveals the error associated with a previous decision, and the bankers associated with that earlier decision will be understandably reluctant to do that. Second, the new managers of the bad bank may have incentives of their own to write down the value of bad bank assets. These incentives to mark-down bad loans aggressively in some ways mirror the incentives of the previous managers to decline to make such mark- downs. By aggressively writing down the value of the assets they acquire, managers of bad banks can improve their own performance. Consider the typical ways in which the managers of bad banks are evaluated. They are evaluated by: (1) how quickly they can dispose of the assets under their control; (2) how the price received for the asset relates to the (newly written down) value of the asset; and (3) whether the bailout cost more than expected. All of these criteria suggest that managers will want to be aggressive initially in seeking write-downs of assets. Assets that have been written down aggressively can be sold easily at prices equal to or greater than their newly assigned values. Setting an initially high estimate of the cost of a restructuring project makes it less likely that new money will be needed. In other words, aggressively writing down the value of the assets of a bad bank causes expectations for the assets to be low. And low expectations are always easier to meet than high expectations. This analysis seems to fit the case of Securum very well. First, Securum worked to insure the impartiality of its personnel by ”trying to ensure that no one worked on the divestment of loan commitments that he had helped to arrange.80 This strategy addressed Akerlof’s “lemons problem” by ensuring Securum’s “credibility outside the company.”81 In fact, decision-makers within Securum who were tied to previous loan commitments were assigned to other jobs, and in some cases forced to resign from Securum. Second, Securum Everyday Life,” D.G. MYERS, ”SOCIAL PSYCHOLOGY” 86 (1992); M. Rabin, Psychology and Economics, 34 J. ECON. LIT. 11–46 (1998). 80 Securum 1992–1997 supra note 11, at 30. 81 Id. 33 implemented an aggressive, incentive-based compensation plan. Securum’s top management acknowledges that “[t]he newly appointed management first had to convince potential employees to make themselves available and then motivate them to work as quickly as possible, despite the fact that this meant they would work themselves out of a job more quickly.”82 Interestingly, the rapid pace with which Securum divested itself of its assets is cited as one of the primary indicia of its mission’s success.83 Finally, it is noteworthy that Securum also cites the fact that “[t]he cost to taxpayers of the financial crisis has been reduced significantly compared with what had been expected when the crisis was at its worst point.”84 In other words, Securum is able to claim success because the original estimates of the problem were so severe. Securum clearly beat the expectations game. Securum, together with its sister organization, Retriva, was originally capitalized with equity of SEK 27.8 billion. Initially, this entire sum was expected to be consumed over the course of the lives of these two institutions. However, Securum was able to return SEK 17.8 billion of the funds originally received. The point here is not that Securum did a bad job. The arguments are far more modest. The first argument is that the organizational structure of Securum created clear incentives for the firm initially to be extremely aggressive in its valuations of the assets that came under its control. The second point is that, in light of this perverse incentive structure, it seems inappropriate as a matter of good social science to use the original estimates of these assets’ values as the benchmark for evaluating Securum’s performance. A more objective benchmark would seem appropriate; however, given the opacity of banks’ balance sheets, it is not at all obvious how a more objective measure might be obtained where there is only a single bidder for the assets of a troubled bank. Perhaps a better approach would be for regulators to attempt to foster competition among bidders for the assets of a bad bank. In this way, the market pressure of competition to acquire the assets would, at least to some extent, counter the incentives of purchasers systematically to give initial underestimates of the value of the bad bank’s assets. 82 Id. at 31. 83 Id. at 2. 84 Id. at 3 (emphasis added). 34 Despite these caveats, the process of moving assets from a troubled bank to a good bank/ bad bank structure does increase the information about the nature of the assets in both the good bank and the bad banks. Despite the biases of the managers of the bad bank discussed above, the new estimates of value for the assets in the bad bank are almost certainly going to be more accurate than the previous (book) values, primarily as a consequence of the managers’ increased expertise and efficiency under the segregated crisis management program. This increase in information due to such restructuring and the concomitant benefits to valuation of assets held by both the bad and good banks should attract investment. A study by Flannery and Sorescu concluded that asset quality tends to have a greater impact on the market than profitability.85 Investors will invest in assets they are able to value with a significant degree of accuracy. Evidence tends to show that investor response has empirically been positive in relation to bad bank restructurings and similar transactions.86 8. Incentives Apart from benefits from specialization and from reductions in the cost of monitoring discussed above, an additional benefit from establishing a good bank/bad bank structure is that such a structure can make it easier to establish compensation systems that reflect both the 85 Mark J. Flannery & Sorin M. Sorescu, Evidence of Bank Market Discipline in Subordinated Debenture Yields: 1983–1991, 51 J. FIN. 1347, 1373 (1996)(“Asset quality and market leverage show the most consistent effect on SND spreads, with profitability less important and interest rate risk generally insignificant.”). 86 INT'L FIN. L. REV., supra note 8, at 34. The following states this positive response: Recent bank merger transactions have illustrated that large special reserves can be established in connection with strategic transactions without unduly adverse consequences. Such reserves have generally been well received by the market, indicating that the capital lost as a consequence of a special reserve can be readily replenished if the institution is otherwise healthy. The market may also be more receptive to bad bank structures. ... Recent experience has also shown that collecting bank activities can be highly profitable. Several large banks (e.g., NationsBank, Banc One, Fleet/Norstar) have achieved significant success in managing troubled assets for their own account and for the account of third parties, including the RTC and FDIC. Id. 35 skills and training involved and the value the use of those skills brings to the bank.87 Specialization and the division of labor facilitate adjustments to salaries based on individual productivity.88 Those who produce more, earn more.89 In the case of bank management, those who manage a greater return on assets should also earn more. As discussed earlier, performance of a bank is difficult to tie to specific assets or to specific decisions when an underperforming bank consolidates the management of both its good and bad assets. “[T]he ‘good’ bank and the ‘bad’ bank can each establish its own unique salary schedule and bonus plan with less internal conflict over who deserves or doesn't deserve a raise.”90 In other words, an incentive structure is more easily enforced under a system of specialized and segregated management. With a properly functioning incentive- based pay system, managerial performance should improve. And, as discussed above, this seems to have been the case with Securum. The generous compensation packages did, in all probability, contribute to the success of the organization. Of course, such compensation packages are more easily defended in private firms than in governmental entities. However, the job insecurity of Securum employees caused by the brief duration of their expected employment periods makes it possible to justify what might otherwise appear to be above- market compensation arrangements. Although the generous compensation packages given to bank managers heighten the incentive to undervalue bad bank assets during the initial stage of crisis management, this is not to say that the compensation packages are inappropriate. In fact, as discussed above, once a system is implemented under which the bad bank assets could be more accurately valued— such as with a competitive bidding system, bad bank managers might well perform even better throughout the crisis management stage. By basing compensation to a greater extent on the actual efficient disposition of the bad assets, and to a lesser extent on the managers’ subjective valuation of the bad assets, the compensation packages might well provide even 87 LUDWIG VON MISES, HUMAN ACTION: A TREATISE ON ECONOMICS 624 (3d rev. ed., 1963). 88 ADAM SMITH, supra note 54, at 97–98. 89 VON MISES, supra note 88, at 625–34. 90 Peter S. Rose, supra note 7, at 44. 36 greater productivity gains than were achieved by Securum. 9. A Brief Look at the Good Bank Non-performing assets have high maintenance and carrying costs. Eliminating these costs immediately improves the position of the good bank. With restructuring, under-performing assets are less likely to be written off as total losses. In other words, if the assets are kept together, the emphasis will be on the performing assets. The gains from those assets will, in effect, cover (or subsidize) the losses attributable to the bad assets. If the assets are split into a good bank/bad bank structure, the performing assets will bring gains alone, and even assuming no gains from specialization, the value of those assets should increase because they will no longer be “guilty by association” with the bad assets. Furthermore, because the bad assets will, presumably, be intensively managed once they are split off, they should, independent of any gains from specialization, bring greater gains than if coupled with the performing assets. A number of scholars have studied the financial outcomes of voluntary corporate restructurings. Many studies have demonstrated, with statistical rigor, that such plans are responsible for immediately increasing the value of those restructured firms.91 There is little reason, other than perhaps the peculiar regulatory posture governing banks, to believe that good bank/bad bank restructurings would not bring similar results.92 91 See, e.g., James A. Miles & James D. Rosenfeld, The Effect of Voluntary Spin-Off Announcements on Shareholder Wealth, 38 J. FIN. 1597–1606 (1983); Kathrine Schipper & Abbie Smith, Effects of Recontracting on Shareholder Wealth, 12 J. FIN. ECON. 437–67 (1983); Gailen L. Hite et al., The Separation of Real Estate Operations by Spin-Off, 12 AM. REAL ESTATE & URBAN ECON. ASSN. J. 318–32 (1984); Gordon J. Alexander et al., Investigating the Valuation Effects of Announcements of Voluntary Corporate Selloffs, 39 J. FIN. 503–17 (1984); James D. Rosenfeld, Additional Evidence on the Relation Between Divestiture Announcements and Shareholder Wealth, 39 J. FIN. 1437–48 (1984); Pren C. Jain, The Effect of Voluntary Sell-Off Announcements on Shareholder Wealth, 40 J. FIN. 209–24 (1985); Gailen L. Hite & James E. Owers, Security Price Reaction Around Corporate Spin- off Announcements, 12 J. FIN. ECON. 409–36 (1983). 92 The Banking Crisis and Financial Reform; Norway; Industry Overview, OECD ECON. SURVEYS—NORWAY, Mar. 1993, at 54. With effective communication of asset quality, the strategy will increase returns: The danger is that the inefficiencies described above will accumulate, and the franchise values of state-owned banks deteriorate. A solution to this problem 37 10. Early Intervention As indicated at the outset, one of the principle observations of this Report is that there is an interesting trade-off between the timing of regulatory intervention in a banking crisis and the likelihood of success of a good bank/bad bank strategy. In particular, this Report maintains that, although early intervention can greatly reduce the costs associated with a bank bailout, it also makes the task of distributing assets between the good bank and the bad bank more difficult. This stems from the fact that bank assets are, by their very nature, highly opaque. Consequently, for many bank assets there may be a wide range of uncertainty about the value of these assets until there is an actual default. Thus, while early intervention is of vital importance in reducing the costs of a bank bailout, the later the intervention, the less controversy there will be over which assets will be allocated to the bad bank, and the easier the task of the managers of the bad bank will be. Securum’s job was made easier by the fact that a majority of the loans taken over by Securum were in default, and that those that weren’t in default “almost without exception soon would be in default.”93 The reason why early intervention is so important is because bank assets that are not dealt with quickly tend to deteriorate in value very rapidly. This is a universal phenomenon that exists in every banking crisis situation. The problem of rapid deterioration of assets was also true in the case of Securum, as it was thought that the value of these assets would have dropped very quickly if not taken over right away.94 Part of the reason why bad bank assets rapidly deteriorate is explained by the moral hazard facing the managers of the distressed bank whose assets are subject to being moved to may be found in the partial or marginal privatisation. ... [One option] is the so- called ‘good bank-bad bank’ method in which profitable operations and customer relationships are separated from doubtful assets, creating two legally- distinct banks. Presuming information about asset quality can be communicated effectively, interests in both banks can be sold to private investors, although only the ‘good’ bank will attract much of a return. Id. (writing in the context of Norway's banking system). 93 Securum 1992–1997, supra note 11, at 29. 94 Id. 38 the bad bank category. Part can be explained by the fact that the managers of distressed banks tend to ignore their banks’ bad assets and focus only on the good assets because they do not want to recognize themselves or draw attention by others to the fact that the bad assets are dropping in value. Also, managers of distressed banks may lack the expertise to deal with these assets in the first place. While there is little, if any, debate over the general policy question of whether early intervention is desirable (clearly it is), there is some debate over the extent to which early intervention is possible in light of the opacity of bank assets. The available evidence suggest that early intervention is, in fact, possible.95 Evidence suggests that the market provides a very good early warning of bank problems. For example, a study by Pettway and Sinkey of six bank failures that occurred between 1973 and 1975 found that the market signaled problems with all of these banks an average of thirty-three weeks before regulatory agencies placed them on problem lists.96 Similarly, a study by Johnson and Weber indicates that the addition of a bank to a regulator's problem bank list does not cause a significant market reaction,97 indicating that the market has already reacted to this information by the time the regulators act. Similarly, when the names of banks on the U.S. Comptroller of the Currency's list of problem banks were leaked to the press there was no significant market reaction to the disclosure, indicating that the market already knew the regulator's information. And a study by Shick and Sherman showed that stock prices of bank holding companies began to decline fifteen months before regulators recognized that the subsidiary banks were experiencing financial trouble.98 95 Anderson and Viotti reach a similar conclusion about the lack of prompt crisis recognition in Sweden. See Martin Anderson & Staffan Viotti, “Managing and Preventing Financial Crisis—Lessons From the Swedish Experience,” PENNING- OCH VALUTAPOLITIK, No. 1, 1999. 96 Pettway & Sinkey, Establishing On-Site Bank Examination Priorities: An Early-Warning System Using Accounting and Market Information, 35 J. FIN. 137, 145 (1980). 97 Johnson & Weber, The Impact of the Problem Bank Disclosure on Bank Share Prices, 8 J. BANK RES. 179, 180–82 (1977). 98 Shick & Sherman, Bank Stock Prices as an Early Warning System for Changes in Condition, 11 J. BANK RES. 136 (1980). 39 Because the market can identify underperforming or soon to be insolvent banks long before failure, implementing a good bank/bad bank strategy prior to insolvency could work to prevent that which might be a foregone conclusion without the strategy. Early intervention could prevent additional damage to a bank’s assets. Thus, regulators should utilize the market as a means for identifying and correcting problems before they ever reach the federal insurer. Rather than create regulations that discourage either a spin-off (or takeover followed by a spin-off ) into a good bank/bad bank system, regulators should encourage the use of any strategy that can minimize the damage to a troubled institution and the damage to the taxpayers. To fully meet this task, regulators should encourage both a market for corporate control for banks and auction markets for the bad assets of distressed banks. The specialization factors encouraging good bank/bad bank restructurings are quite similar to the factors involved in a takeover. After all, takeovers are motivated by an acquiring institution’s belief that it has a superior ability to manage the acquired institution. In other words, it has a comparative advantage. When a bank takeover is attractive only when the acquiring institution can establish a good bank/bad bank system following acquisition, the cost of accomplishing that takeover is especially high because the acquiring institution must overcome the regulatory hurdles it faces in both acquisition and restructuring. Thus, impediments to an open market for bank control diminish the instances of both control transactions as well as good bank/bad bank restructurings. Because intervention can occur early on in a bank’s crisis, “[t]he good bank-bad bank structure is most effective at the time it first becomes apparent that the institution cannot generate core-operating profits until non-performing assets are significantly reduced.”99 It is important to note that many poorly functioning banks could be averted from failure by preemptive reorganization. Takeovers (including takeovers that come in the form of auctions organized by regulators) are perhaps the most efficient means by which this is accomplished, where the acquiring institution is able to identify under-performing banks and intervene to reorganize the acquired institution. In other words, the motivations that have led to successful corporate reorganizations could also be accomplished in the banking industry—partially through utilizing the good 99 Hurley, supra note 7, at 4. 40 bank/bad bank strategy—if the market for bank control could be improved. These insights about takeovers are relevant in this context because the available literature in financial theory indicates that weak and failing firms (especially those with weak management teams) are particularly likely candidates for takeover, because they are likely to provide the greatest opportunity for arbitrage profits by superior management teams. They are prime candidates for an acquiring firm able to provide separate, specialized management under the good bank/bad bank scenario. Indeed, in an insight that is particularly relevant for banking law and policy, Professor Dewey observes that takeovers are “merely a civilized alternative to bankruptcy or the voluntary liquidation that transfers assets from falling to rising firms.”100 Thus, when properly viewed as a substitute for bankruptcy, a robust market for bank control is seen as a sign of the vigor of competition in a particular industry, rather than of its decline.101 Professor Henry Manne, in a seminal article, made a substantial extension of Dewey's earlier insights. He observed that takeovers are not only efficient when the failure of a firm is imminent, but also “before bankruptcy becomes imminent in order to avoid that eventuality.”102 Manne goes on to point out that “if mergers were completely legal, we should anticipate relatively few actual bankruptcy proceedings in any industry which was not itself contracting. The function so wastefully performed by bankruptcies and liquidations would be economically performed by mergers at a much earlier stage of the firm's life.”103 Manne's defense of the market for corporate control catalogues a host of advantages to the 100 Dewey, Mergers & Cartels: Some Reservations About Policy, 51 AM. ECON. REV. PAPER & PRAC. 255, 257 (1961). 101 Id. This does not mean that takeovers of banks will only occur when failure is imminent. Rather, takeovers are likely to take place whenever a firm is being run by inept or dishonest management, even if the firm happens to be profitable. See Haddock, Macey & McChesney, Property Rights in Assets and Resistance to Tender Offers, 73 VA. L. REV. 701, 709 (1987). It stands to reason, however, that all else being equal, firms with inept or dishonest management are more likely to fail than firms with competent, honest management. Takeovers also are likely to occur when a firm's assets could be redeployed to more valuable uses than the ones selected by incumbent management. Macey, State Anti-Takeover Legislation and the National Economy, 1988 WIS. L. REV. 467, 469 (1988). 102 Henry Manne, Mergers and the Market for Corporate Control, 73 J. POL. ECON. 110, 111 (1965). 103 Id. at 112. 41 economy from a regulatory policy that encourages takeovers. A free market for corporate control would bring about more efficient management of firms, increased protection for non- controlling investors—stockholders, depositors, and other creditors—and a more efficient allocation of resources.104 The arguments in support of a robust market for corporate control apply with even greater force to banks than they do for corporations generally. The monitoring function that the corporate control market provides for all firms is a supplement to the monitoring conducted by unsecured creditors in the case of the public corporation where creditors are not protected by the government. Because depositors have very little incentive to engage in monitoring under the current regulatory regime, which protects virtually all deposits, the need for a robust market for corporate control is even more acute in banking than in other sectors of the economy. The observations of Dewey and Manne that the market for corporate control both serves as a substitute for bankruptcy and reduces the incidence of insolvency are particularly relevant for the banking industry. Outside of banking, the creditors and shareholders who make (uninsured) investments in a firm that becomes insolvent bear virtually all of the costs of the insolvency. But if a bank becomes insolvent, much of the costs are borne not by shareholders and uninsured creditors of the failed institution, but by the state. This provides an even stronger argument for facilitating a robust market for corporate control—including state-sponsored auctions—in order to reduce both the incidence of bank failures, and the costs of those failures that do occur. 11. Conclusion Bad banks are a useful and important strategy for dealing with the problems of failing banks. The Swedish approach to its banking crisis involved perhaps the most committed and pervasive division of ailing financial institutions into a good bank and a bad bank ever attempted. Once in the bad bank, the asset received careful attention so that it could be packaged and improved in order to be made attractive to potential buyers as quickly as 104 See Frank H. Easterbrook & Daniel R. Fischel, Corporate Control Transactions, 91 YALE L.J. 698, 698 (1982); Haddock, Macey & McChesney, supra note 102, at 709. 42 practicable. There is no question that the utilization of a bad bank framework is superior to leaving bad assets in the distressed banks that made the original commitments. The use of the bad bank framework such as that utilized in Securum facilitates a more accurate (albeit not perfect) assessment of the real value of the assets of the troubled bank. In addition, the utilization of the bad bank structure allows for the deployment of highly specialized experts to bring their particular skills to bear on resolving the assets taken by the troubled bank. It is the conclusion of this Report, however, that a proper evaluation of the Swedish experience with the financial crisis of the early 1990s would be seriously incomplete if it focused exclusively on the crisis management conducted by Securum. Instead, it is important to examine the entire response sequence, which includes not only the crisis management conducted by Securum—and Sweden´s Bank Support Authority—, but also the crisis prevention carried out by the Ministry of Finance, the Sveriges Riksbank (Swedish central bank), and the Financial Supervisory Authority. The delays associated with lack of early closure in the crisis prevention phase of the Swedish financial crisis had two consequences. First, the delays increased the overall costs associated with the crisis by permitting bank assets to deteriorate prior to coming under Securum’s control. Thus, regardless of how efficiently Securum functioned, the overall crisis management component cannot be viewed as a success without also considering the costs associated with the lack of early intervention. Second, the delay made Securum’s job easier by lowering the difficulty of identifying, categorizing, sorting and valuing the bad assets. Put simply, when there is early intervention, the decisions about which assets to allocate to the bad bank and which to retain in the good bank are more difficult. While the causes of the delay may be political in nature, rather than resulting from an inherent flaw in the good bank/bad bank strategy, it is important to recognize the potential costs associated with the delay when assessing Securum’s overall performance. Thus, delay in intervening to deal with a financial crisis may raise the overall costs of resolving the crisis, but it makes the task of the managers of the bad bank easier. This is particularly true where—as in the case of Securum—the bad bank is evaluated on the basis of the difference between what was expected when the crisis was at its worst point and the ultimate value received for assets by the bad bank. This evaluation scheme creates an 43 incentive structure in which the bad bank’s performance is a straightforward function of the value of the assets that come under its control. All else equal, the lower the initial values, the better the bad bank’s ultimate performance will be judged to have been. In the case of the Swedish financial crisis, the problem was not so much that intervention came late: the problem was that the extent of the crisis was exaggerated. The available evidence suggests that there was overreaction and panic in the face of what were, in reality, temporary liquidity problems within the Swedish banking industry. This atmosphere of crisis and panic made Securum’s job easier by creating a climate in which it was possible to understate the value of the assets being transferred to Securum. It is important to stress once again that this is not meant as a blanket criticism of Securum. The point is not that Securum did a bad job. Rather, the point is simply that taking an estimate of the value at the time they come into the bad bank does not permit an unbiased, market-tested mechanism for establishing an initial benchmark against which to evaluate the bad bank’s performance. This Report suggests alternatives such as setting up an auction, or facilitating a takeover or merger or similar control transaction that would ameliorate this problem. As things stand with the case of Securum, it will be extremely difficult to obtain an objective, empirical measure of the success of the organization because it will not be possible to know for certain how well the assets would have performed in some alternative ownership structure. This Report offers some reasons why Sweden’s experience with Securum might not be easily exportable to other economies currently undergoing financial problems. First, the sort of specialized human capital skills that were brought to bear in Securum to deal with the distressed assets put under its control simply may not be available in other economies experiencing financial crisis. It is the availability of such specialized talent that forms the core economic justification for establishing a bad bank structure. Absent such qualified personnel with industry specific know-how, it is not obvious that a good bank/bad bank structure could be made to work. Second, Sweden is an unusually honest country. Before introducing a Securum-like structure in another country, one would have to consider whether it is possible to establish an independent, entrepreneurial organization empowered to dispose of assets of significant value without the problem of corruption destroying any value-added that might be derived from that 44 organization’s activities. The same point can be made about the assets that came into Securum’s control. Securum established an irregularity committee to deal with fraud and other irregularities in its loan commitments. However, while approximately half of the loan files were subject to some form of criticism, fraud was proven in only a limited number of cases. This relatively low level of fraud in connection with the assets coming into Securum’s possession reduced Securum’s initial business risks and lowered the adverse financial consequences associated with Securum’s activities. It is not obvious that this happy experience would be replicated in other contexts. Along these lines, it is particularly noteworthy that many of Securum’s employees came from Nordbanken. This significantly reduced the “learning curve” associated with becoming familiar with Securum’s assets. However, in a situation where fraud and self-dealing are more pervasive, this sort of hiring pattern would not be possible. Third, as mentioned above, certain other factors contributed to Securum’s ability to operate efficiently. Securum took a relatively small number of large assets. Such assets were easier to manage than a larger number of small assets would have been. Securum, like its sister entity Retriva, took all of its assets from a single entity. This entity was Nordbanken in the case of Securum and Gota Bank in the case of Retriva. This rather unique situation contributed to the speed and flexibility with which these bad banks were able to operate. The bad banks could adapt themselves to the organization structure and geographic organization of the banks from which they obtained their assets. And Securum was able to compensate its personnel both generously, and on a performance basis. This, too, may be difficult to replicate in other cultures. The rather unique nature of the Swedish financial crisis can be illustrated with reference to the issue of crisis recognition. This Report stresses that the most important variable in controlling the costs of a financial crisis is early crisis recognition. It is highly unlikely that the rather peculiar Swedish experience with early recognition will ever be replicated elsewhere. Unlike most jurisdictions (including the U.S. and Japan, as well as most of the rest of Asia), where both regulators and bankers ignored the severity of the banking crisis and engaged in regulatory forbearance by declining to close banks that should have been closed, in Sweden the banks themselves voluntarily went to the government, described 45 the nature of the crisis and the extent of the problem, often in exaggerated terms.105 And, as suggested above, if anything, Swedish regulators and bankers exaggerated the severity of the problems facing the Swedish banks, rather than ignoring the problem for years as was done in many other countries. As I observed in a 1994 Report: [f]ar from ignoring the problem, in Sweden there was a general overreaction. ... Unlike the situation in the U.S. and internationally. ... where regulators had to fight bankers in order to obtain control of troubled banks, Swedish banks have applied to the government for regulatory assistance voluntarily. ...106 In contrast to the regulatory responses to the banking crisis in other countries, the response to the crisis in Sweden was quick and more severe than truly necessary given the true nature of the problems. In other words, the error bias in most countries has been in the direction of ignoring the severity of the banking crises with which they have been faced. In Sweden, by contrast, the error bias has been in the direction of overreaction. This Report has raised the possibility that this overreaction may provide some explanation for the apparently exemplary performance of Securum. 105 Jonathan R. Macey, “The Future Regulation and Development of the Swedish Banking Industry,” SNS Occasional Paper No. 56, May, 1994. 106 Id. at 66. 46
"Are Bad Banks the Solution to a Banking Crisis"