Doubts rising over plan to fix banks

The credit breakdown has direct consequences for the economy.

The unemployment rate has jumped from 5 percent to 8 percent in the past year, with the breakdown in the banking system playing a big role, shaking consumer confidence and fraying business access to credit.

Agreed: Banks hold key
Financial-industry policies are just part of a larger web of economic recovery programs that the Obama administration is pursuing, in concert with the Fed. But those financial policies must succeed, Obama and his critics both say, to enable any economic rebound.

Treasury Secretary Timothy Geithner has unveiled the outlines of a “financial stability plan,” which has two elements to help banks that are being hit by a wave of loan defaults.

First, regulators are assessing the health of the largest banks, to see which banks need to raise fresh capital to weather the recession. If a bank needs capital and can’t get it from private investors, the Treasury plans to provide it.

Second, Mr. Geithner is working to set up a public-private investment fund that will buy troubled loans at marked-down prices, as a way of helping to clean up bank balance sheets.

Separately, officials including Geithner and Federal Reserve Chairman Ben Bernanke are responding to the emergencies that some big corporations find themselves in. Last week’s enlarged bailout for AIG came just days after the bank Citigroup got new assistance.

Together, these steps might prove to be effective, but they are also drawing criticism.

Two camps of economists

Finance experts generally agree that the banking system needs more capital, because loan losses eat away at banks’ existing capital reserves. But beyond that, broad differences exist.

Economists in one camp call for tougher conditions or limits on federal aid to banks. One reason is concern about the adverse impact on government finances if the rescue tab keeps climbing into trillions of dollars. Another reason is “moral hazard,” the idea that bailing out institutions sows the seeds of future crises, by embedding assumptions of government support.

“We have to think hard about what incentives we’re setting up,” says Mr. Mason of Louisiana State University.

He likens the regulator-bank relationship to that of a parent and child. If the parent always helps the child out of messes, the problems escalate.

“Each time it gets more and more costly to do so,” he says. “You have to let the market [participants] in this case feel the weight of their own losses.”

In another camp are economists who may agree that moral hazard is a concern, but who argue that discipline and new rules will come later. The first task is to make sure the financial industry remains operational.

Another dividing line between these two camps relates to estimates of the problem’s scope.

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