The Right Way for Banks to Bail Themselves Out

The politicians are urging big taxes on banks, using rhetoric designed to trick people into thinking that this is a way to make the banks pay for their own bailouts. But a general tax on all banks simply means that well-run banks subsidize the reckless banks - a problem that may get worse over time because of the moral hazard problems that seem to get worse every time politicians get more power over the industry. Greg Mankiw of Harvard has a more appealing idea, which would require automatic conversion of bonds to equity when a bank gets in trouble. This means, for all intents and purposes, that a bank would only be in a position of bailing itself out, so there is no risky cross-subsidization. And since bondholders presumably would not want to be converted into shareholders, there would be greater incentive to monitor whether the bank is being operated in a prudent manner. I'm not an expert on the specifics of the banking system, so I won't pretend to know enough to give this my unqualified blessing, but I know it is a far better approach than the blank-check bailout/intervention authority in the legislation on Capitol Hill:

There has been much talk about restricting the use of financial derivatives. Unfortunately, writing good rules is not easy. Derivatives, like fire, can lead to disaster if not handled with care, but they can also be used to good effect. Whatever we do, let’s not be overoptimistic about how successful improved oversight will be. The financial system is diverse and vastly complicated. Government regulators will always be outnumbered and underpaid compared with those whose interest it is to circumvent the regulations. Legislators will often be distracted by other priorities. To believe that the government will ever become a reliable watchdog would be a tragic mistake. ...Much focus in Washington has been on expanding the government’s authority to step in when a financial institution is near bankruptcy, and to fix the problem before the institution creates a systemic risk. That makes some sense, but creates risks of its own. If federal authorities are responsible for troubled institutions, creditors may view those institutions as safer than they really are. When problems arise, regulators may find it hard to avoid using taxpayer money. The entire financial system might well become, in essence, a group of government-sponsored enterprises. ...My favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance. Bankers may balk at this proposal, because it would raise the cost of doing business. The buyers of these bonds would need to be compensated for providing this insurance. But this contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.