Wednesday, November 6, 2013

Should failing banks be closed suddenly or slowly: Laurence Kotlikoff versus Positive Money.

If all the creditors of a bank (or indeed any other entity) are shareholders (or other types of creditors who are shareholders in all but name), then when the business does badly, the value of its assets and the value of its shares will decline.
But that’s not a reason to declare bankruptcy or insolvency: indeed the above “doing badly” scenario simply does not constitute bankruptcy or insolvency as per the definition of the latter two words. Those definitions include something to the effect that the entity owes its creditors a sum of money which the entity cannot pay. 
But if all creditors are shareholders and quasi shareholders, then the entity does not owe any specific sum of money to anyone. George Selgin in his book “The Theory of Free Banking” (available online for free) made the same point when he said “For a balance sheet without debt liabilities, insolvency is ruled out..”.
Under Kotlikoff’ssystem, all creditors are quasi-shareholders, so insolvency is “ruled out”.

Positive Money.
Positive Money advocates a system under which depositors are promised £X back for every £X they deposit. That applies to PM’s so called “investment accounts” as well as “safe accounts”. But when things go wrong and the bank cannot repay depositors their £X, the bank is declared insolvent. And investment account depositors get 80p in the £ or whatever.
However given the same level of bank incompetence as above, 80p or thereabouts is what the “£1 stakes” of depositors would be worth in a Positive Money scenario.
So what’s the point of declaring a bank insolvent? Not much!!!

Why declare ANY BUSINESS bankrupt?
The above arguments actually raise an interesting question: namely what’s the point of declaring ANY FIRM bankrupt? That is, when a firm does badly, and creditors’ stakes in the business are obviously not worth their paper value, those creditors are always free to sell their stakes. E.g. trade creditors can always sell to those who specialise in “debt factoring” as it’s called. (Most UK banks offer a factoring service.)
There are probably others who can answer the latter question better than I can (the question as to what the point of formal insolvency proceeds is). However, I’ll make just one point against declaring banks insolvent, as follows.
Half (or more) of the damage done from banks going bust is the SUDDENNESS of the process. That is, the relevant bank tries to pretend up to the last minute that everything is OK and depositors’ stakes are worth 100p in the £. But at some point the game is up: everyone realises their stakes are not worth 100p in the £, so they rush to withdraw their stakes while the bank is still paying. Then hours later (rather than days later) the bank closes its doors.
So in the case of banks (as distinct from other businesses) there is a good case for the “slow decline” process as distinct from the SUDDEN close down process that is involved in formal insolvency.
Conclusion:  Kotlikoff’s slow decline process is better than Positive Money’s “sudden” closure process . . .er . . . I think.

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